13 TREASURY AND WORKING CAPITAL MANAGEMENT Glen Arnold: Corporate Financial Management, Second...

13 TREASURY AND WORKING CAPITAL MANAGEMENT

Glen Arnold: Corporate Financial Management, Second edition© Pearson Education Limited 2002

OHT 13.1

• Describe the main roles of a treasury department and the key concerns of managers when dealing with working capital

• Comment on the factors influencing the balance of the different types of debt in terms of maturity, currency and interest rates

• Show awareness of the importance of the relationship between the firm and the financial community

• Demonstrate how the treasurer might reduce risk for the firm, perhaps through the use of derivative products

• Understand the working capital cycle, the cash conversion cycle and an inventory model

LEARNING OBJECTIVES



OHT 13.2

WORKING CAPITAL

• The difference between current assets and current liabilities

• Net current assets (net current liabilities)

• Working capital encompasses:Short-term resources

• Inventory

• Debtors

• Investments

• Cash

Less

Short-term liabilities

• trade creditors

• short-term borrowing

• other creditors payable within a year



OHT 13.3

Exhibit 13.1 The main areas of treasury and working capital management

Financing• How much to borrow?• Type of finance.• Balance of finance.• Advice, e.g. merger financing, gearing.• Relationships with the financial community:

– Shareholder relationships;– Number of banks;– Relationships versus transactional banking.

Aspects

Risk management• Business risk.• Insurable.• Currency risk.• Interest rate risk.

Working capital andliquidity management• Working capital cycle.• Cash management.• Investment of temporary surplus cash.• Inventory management.• Creditor management.• Debtor management.

Treasury andworking capital

management

RISK

CASH FLOW

Key considerations



OHT 13.4



OHT 13.5

Treasurer and financing decisions

• Borrowing long or short?• To match or not to match?• Currency of borrowing?• Interest rate type?• Retained earnings as a

financing option?• Strategic considerations• Advice (e.g. merger financing,

gearing)• Relationships with the financial

community



OHT 13.6

Is it better to borrow long or short?

• Short-term debt• Medium-term debt• Long-term debt

Considerations

• Maturity structure

• Cost of issue/arrangement

• Flexibility

• The uncertainty of getting future finance

• The term structure of interest rates



OHT 13.7

Exhibit 13.3: An example of a company conscious of the necessity for a range of maturity dates for debt – Thames Water plc

0

50

100

150

200

1996 2000 2005 2010and

beyond

£m

Gross debt maturity profile

£m



OHT 13.8

Exhibit 13.5 A shifting yield curve affects the relative cost of long- and short-term borrowing – the example of Rosa plc

10%

8.3%8%

7%

1 4 5

Years to maturity

Interest rate

The yield curve at time zero

The yield curve at time 1(one year after the initial loan)

Inte

rest

rat

e



OHT 13.9

Exhibit 13.6 Moderate financing policy stance – the matching principle

Time

£

Short-term finance

Long-term finance(debt and equity)

Fixedassets

Permanentcurrentassets

Fluctuatingcurrentassets



OHT 13.10

Exhibit 13.7 An aggressive financing policy

Time

£

Short-term finance

Long-term finance(debt and equity)

Fixedassets





OHT 13.11

Exhibit 13.8 A conservative financing policy

Time

£ Long-term finance(debt and equity)

Fixedassets



Available for investment in short-termfinancial instruments



OHT 13.12

Advantages• No dilution of the existing shareholders’ share

of corporate control or share of returns• Retaining earnings avoids the issuing costs• Management do not have to explain in such

detail the use to which the funds will be put(a dubious advantage for shareholders)

Disadvantages• Limited by the firm’s profits• Using retained earnings means reducing the

dividend payout• Uncertain as fluctuate with the company’s

fortunes• Many managers regard them as essentially

‘free capital’

RETAINED EARNINGS AS A FINANCING OPTION



OHT 13.13

Relationships with the financial community

• Planned, sustained effort to maintain mutual understanding between shareholders and company

• Banking relationships

– Multiple banks

– Transaction banking vs. relationship banking



OHT 13.14

Three reasons firms sacrifice some potential profits in order to reduce the impact of adverse events:

1 It helps financial planning

2 Reduces the fear of financial distress

3 Some risks are not rewarded

RISK MANAGEMENT



OHT 13.15

• Business risk

• Insurable risk • Currency risk • Interest-rate risk

TYPES OF RISK



OHT 13.16

Exhibit 13.10 A typical working capital cycle and other cash flows

WORKING CAPITAL MANAGEMENT

Cash

Medium-term finance:leases, HP

Long-term debt Fixed assets

TaxationShareholders

Trade creditors Trade debtors

Operation costs:Labour, overheads

marketing,distribution, etc.

Raw materials Finished goods stock

Sale

Work-in-progress

The working capital cycle

Other cash flows



OHT 13.17

Exhibit 13.11 The cash-conversion cycle as part of the working capital cycle

Exhibit 13.12 Summary of cash-conversion cycle

CASH-CONVERSION CYCLE

Credit periodgranted bysuppliers

Debtor-conversion

period

Stock-conversion

period

Cash-conversion

cycle–+=

Raw materialstock period

Work-in-progressperiod

Finished goodsinventory period

Debtor conversionperiod

Credit periodgranted bysuppliers

Stock-conversion period

Cash conversion cycle

Inputpurchased

Debtorpays

Creditorpaid

Productionstarts

Productioncompleted

Outputsold



OHT 13.18

Exhibit 13.13 Calculation of cash-conversion cycle

• Raw materials stock period The average number of days raw materials remain unchanged and in stock:

Less• Average credit period granted by suppliers The average length of time between the purchase of inputs and payment of them:

Add• Work-in-progress period The number of days to convert raw materials into finished goods:

Add• Finished goods inventory period The number of days finished goods await delivery to customers:

Add• Debtor-conversion period The average number of days to convert customer debts into cash:

Raw materials Average value of raw materials stockstock period Average purchase of raw materials per day = X days =

Credit period =Average level of creditors

Purchases on credit per day= X days

Work-in-progressperiod =

Average value of work-in-progressAverage cost of goods sold per day

= X days

Finished goodsinventory period

=Average value of finished goods in stock

Average cost of goods sold per day= X days

Debtor conversionperiod =

Average value of debtorsAverage value of sales per day

= X days



OHT 13.19

Exhibit 13.14 Figures invented in order to calculate a cash-conversion cycle

The cash-conversion cycle is the length of time a pound is tied up in current assets. For the figures given in Exhibit 13.14 it is:

Raw materials stock period = 23,000,000

295,890 = 78 daysLess creditor period* = 13,000,000

295,890 = – 44 daysWork-in-progress period = 10,500,000

378,082 = 28 daysFinished goods inventory period = 9,500,000

378,082 = 25 daysDebtor-conversion period = 31,000,000 438,356 = 71 daysCash conversion cycle = 158 days

*Note: This is simplified to the creditor period on a single input, raw materials – there will be other inputs and creditors in most firms

20X1 20X2 Mean Per day£m £m £m £000s

Raw materials inventory 22 24 23Creditors 12 14 13Work-in-progress inventory 10 11 10.5Finished goods inventory 9 10 9.5Debtors 30 32 31Sales 150 170 160 438,356Raw material purchases (annual) 100 116 108 295,890Cost of goods sold (annual) 130 146 138 378,082



OHT 13.20

Exhibit 13.16 Working capital tension

Loss of productionand sales due to too

little working capital.Loss of customer

goodwill.

Costs of tying upfunds. Storage,handling and

ordering costs.

Liquidity risk

versus

Shortage costs Carrying costs



OHT 13.21

Exhibit 13.17 Working capital periods

THE DYNAMICS OF WORKING CAPITAL

Stock-conversion period (raw material + work-in-progress + finished goods periods) 2 months

Debtor conversion period 1.5 monthsCreditor period 1 month

Assuming that the input costs are 60 per cent of sales the working capital investmentwill be £1,750,000:

Stock 60% £10m 2/12 1,000,000Debtors £10m 1.5/12 1,250,000Creditors 60% £10m 1/12 –500,000

£1,750,000



OHT 13.22W

OR

KIN

G C

AP

ITA

L P

OL

ICIE

S

Exh

ibit

13.

18 W

ork

ing

cap

ital

ch

ange

s w

hen

sal

es r

ise

by

50 p

er c

ent

Con

vers

ion

peri

ods

Pos

sibi

lity

1P

ossi

bili

ty 2

Pos

sibi

lity

3

Sto

ckC

onst

ant @

2 m

onth

sIn

crea

se to

3 m

onth

sD

ecre

ase

to 1

mon

ths

Deb

tors

Con

stan

t @ 1

mon

ths

Incr

ease

to 2

mon

ths

Dec

reas

e to

1 m

onth

Cre

dito

rsC

onst

ant @

1 m

onth

Incr

ease

to 1

mon

ths

Dec

reas

e to

m

onth

£m£m

£m

Sto

ck60

%

£1

5m

2/12

=1.

560

%

£1

5m

3/12

=2.

2560

%

£1

5m

1/1

2=

1.12

5

Deb

tors

£15m

1/1

2=

1.87

5 £1

5m

2/12

=

2.50

£15m

1/12

=1.

250

Cre

dito

rs60

%

£

15m

1/12

=–0

.750

60%

£

15m

1/1

2=

–1.

125

60%

Wor

king

cap

ital

2.62

53.

625

2.0

inve

stm

ent

Abs

olut

e in

crea

se0.

875

1.87

50.

25

Per

cent

age

incr

ease

over

£1.

75m

50%

107%

14%

£15m

1 /

2 /1

2

=

–0.

375

1 /2

1 /2

1 /2

1 /2

1 /2

1 /21 /

2



OHT 13.23

Exhibit 13.19 Policies for working capital

20 40 60 80

5

10

15

20

25

Sales £

Aggressive

Moderate

Relaxed

Note: The numbers are illustrative and do not imply a ‘normal’ relationship between sales and current assets.

Wor

king

cap

ital

£



OHT 13.24

Overtrading occurs when a business has insufficient finance for working capital to sustain its level of trading.

Bits and Rams Ltd1999: Turnover of £2m and a profit of £200,000.

£000Turnover 2,000Cost of goods sold 1,800Profit 200

• All costs are variable• Debtors generally take two and a half months to pay• Inventories are for two months’ worth of cost sales• Trade creditors are paid one and a half months after delivery

In 2000 sales doubled

Turnover 4,000Cost of goods sold 3,600Profit +400

Additional investment in debtors (2,000 21/2/12) –417Additional investment in inventories (1,800 2/12) –300Tax bill from previous year’s trading –67Increase in trade creditors (1,800 11/2/12) +225

Cash flow –159

Exhibit 13.20 Cash flow for Bits and Rams Ltd

OVERTRADING

£000



OHT 13.25

1 Transaction motive

2 Precautionary motive

3 Speculative motive

WHY IS CASH SO IMPORTANT?



OHT 13.26

versus

Exhibit: 13.21 The cash trade-off

.

• Loss of interest.

• Loss of purchasing power – inflation erodes the value of cash.

Cost of holding cash

• Annoyance of those to whom payment is due if payments are not made on time. Could lead to reluctance to supply. Can eventually lead to liquidation.

• Inability to cope with emergencies, e.g. competitor’s action, fire, strikes, bad weather.

• Opportunities missed, e.g. contracts, buying another business.

• Loss of discounts from suppliers by not having cash to pay early.• Higher cost of borrowing because unexpected cash needs have to be met from temporary borrowing rather than drawing on cash balances.

• Credit rating might fall because of low current and acid test ratios.

• Regular payments have to be made to top up the cash balances, e.g. transaction cost of selling securities to release cash and arrangement fees for overdrafts.

Costs of holding too little cash



OHT 13.27

• Cash used at a constant rate• Pays out £100,000 per week• Receives a steady inflow of £80,000 per week• Need for additional cash of £20,000 per week• Beginning cash balance of £80,000• Arrangement fees on £80,000 of borrowing or the transaction

costs of selling £80,000 of Treasury bills are £500.

BAUMOL’S CASH MODEL

Exhibit 13.22 Cash balances for Cypressa plc with Baumol’s model assumptions

1 2 3 4 5 6 7 8 9 10 11Week

Averagecash balance

£40,000

Cash balance£80,000

Maximum Q



OHT 13.28

Exhibit 13.23 Finding the optimum cash balance

The following factors to help establish the position of Q mathematically: Q = maximum cash balance Q/2 = average cash balance C = transaction costs for selling securities or arranging a loan A = total amount of new cash needed for the period under consideration; this is usually one year K = the holding cost of cash (the opportunity cost equal to the rate of return forgone)

The total cost line consists of the following:

Average amount tied up Opportunity cost + Number of transactions Cost of each transaction

The optimal cash balance Q is found as follows:

Combined costof holding cash

Opportunity costof cash

Transaction costs

Optimum (maximum)cash balance, Q*

Cash balance (maximum, Q)

Cost of cash balance £

Cos

t of

cash

bal

ance

£

+Q

2 Q

AK C

Q* = 2CA

K



OHT 13.29

Assume the interest rate K is 7 per cent. The annual need for cash is (£20,000 52) = £1,040,000. The optimal amount to transfer into cash on each occasion is:

Cypressa should replenish its cash balances to the extent of £121,890.The number of times replenishment will take place each year:

A/Q* = £1,040,000/£121,890

= between eight and nine times a year.

Q* =2 £500 £1,040,000

0.07= £121,890



OHT 13.30

• Create a policy framework

• Plan cash flows

Exhibit 13.24 Cash planning

SOME CONSIDERATIONS FOR CASH MANAGEMENT

Jan Feb Mar Apr May June July Aug Sep Oct Nov Dec

Constant cash outflows

Cash inflow

Cash surplus

Cash £

Cas

h £



OHT 13.31

Exhibit 13.25 Cedrus plc: sales

Sales £000s

Total Paid for in month Paid for 1 monthof delivery later

August 90 30 60September 90 30 60October 120 40 80November 150 50 100December 600 200 400January 60 20 40



OHT 13.32

Exhibit 13.26 Cedrus plc cash budget

£000s Aug Sep Oct Nov Dec Jan

Cash inflowsS ales (delivered and paid for in same month) 30 30 40 50 200 20Sales (cash received from prior month’s sales) 60 60 60 80 100 400

Total inflows 90 90 100 130 300 420

Cash outflowsPayments for materials 50 50 55 55 55 55Wages 20 20 22 25 30 22Rent 10 10 10 10 10 10Other expenses 10 10 11 9 10 11New machine 100Advertising 50Tax 150

Total outflows 90 90 198 149 105 248

BalancesOpening cash balance for month 50 50 50 (48) (67) 128Net cash surplus (deficit) for month – 0 0 (98) (19) 195 172

inflows minus outflowsClosing cash balance 50 50 (48) (67) 128 300



OHT 13.33

• Set in place a co-ordinating system to ensure that funds are transferred from where there is surplus to where they are needed

• Funnel money to the centre

• Cash flow synchronisation

• Cash budget

• Delays in the cheque-clearing system

• The float

CONTROL CASH FLOWS



OHT 13.34

Exhibit 13.27 The delays in clearing a cheque

Customer writes cheque and sendsit by post.

Supplier receives cheque.

Supplier pays in cheque at bank.

Cheque is cleared through bankclearing system – supplier’s account

is credited, customer’s account isdebited.

1–2 days

1 day

2–4 days



OHT 13.35

Exhibit 13.28 The inventory trade-off

INVENTORY MANAGEMENT

• High ordering cost• Cost of ‘stock-outs’

– loss of sales– loss of profits– loss of goodwill– production dislocation

• Cost of tying up cash(lost interest)

• Storage costs• Management costs• Obsolescence• Deterioration• Insurance costs• Protection (e.g. security

patrols)

versus

If low inventory levelsthen risk is:

If high inventory levelsthen:



OHT 13.36

Exhibit 13.29 Stock levels over time in a predictable environment

INVENTORY MANAGEMENT MODELLING IN A WORLD OF UNCERTAINTY

Time

Q/2

QMaximum inventory

Average inventory

Zero inventory



OHT 13.37

Exhibit 13.30 Optimum inventory cost

• C is the cost of placing each order• A is the annual usage of the inventory items• H is the cost of holding one unit of stock for one year

The annual ordering costs = Number of orders per year Cost of each order = A/Q C

Combined costs

Holding costs

Ordering costs

Economic order quantity

Order quantity (units)

Costs £

and:The cost of holding stock = Average stock level (in units) Cost of holdingeach unit = Q/2 H

The total cost is:

AC HQ+

Q 2

If this total cost equation is differentiated with respect to EOQ and the derivativeis set equal to zero the EOQ which gives the lowest total cost will be:

2ACEOQ =

H

or HQ 2

Cos

ts £

or AC

Q



OHT 13.38

Exhibit 13.31 Inventory level pattern where there is a delay between order and delivery

1 2 3 4 5 6 7 8 9Weeks

2,000

8,000

Inventory (units)

Reordering at 2,000 unitsin weeks 3 and 7 for deliveryin weeks 4 and 8

Inve

ntor

y (u

nits

)



OHT 13.39

Exhibit 13.32 Inventory level pattern when there is uncertainty over the lead time

1 2 3 4 5 6 7 8 9 10 11 12 13 14

2,000

4,000

8,000

10,000

Inventory (units)

Reorder level

4th period3rd period2nd period1st period

Lead time Lead time Lead time

Weeks

Inve

ntor

y (u

nits

)



OHT 13.40

Exhibit 13.33 The credit trade-off

• If trade credit is not takenalternative sources of finance mayhave to be used, which maybe costly.

• Paying all bills on delivery mayinvolve more administrationexpense than paying through adelayed account system.

• Passing up of lowerprices/discounts.

• Loss of reputation/goodwill iflate payment is pushed too far..

• Administration costs ofmanaging of trade creditorrecords and making payments.

versus

Costs of not taking trade credit Costs of accepting trade credit



OHT 13.41

Short-term cash surpluses arise for a number of reasons:

• Seasonal or cyclical business

• To meet large outflow events

• A firm may have sold an asset or raised fresh borrowing but have yet to direct that money to its final use

• Surprisingly good control of working capital

INVESTMENT OF TEMPORARY SURPLUS FUNDS



OHT 13.42

Exhibit 13.34 The short-term investment trade-off

Event risk

Valuation risk

Inflation risk

Default risk

Liquidity risk

versusMaximisingreturn



OHT 13.43

1 Defining the investable funds

2 Acceptable investment

3 Limits on holdings

INVESTMENT POLICY



OHT 13.44

Exhibit 13.36 Some of the investments available to a corporate treasurer

‘Sight’ deposit at a bank,e.g. current account

Instant withdrawal – highly liquid but low interest rate.

Time deposit at a bank Some notice is required to withdraw funds.

Interbank lending:(a) Sterling(b) Foreign currencies

Banks and others borrow and lend to each other.

Certificate of deposit (CD) A company agrees to lock away a sum (e.g. £500,000) in abank deposit for a period of between three months andfive years. The bank provides the company with a certificateof deposit stating that the bank will pay interest and theoriginal capital to the holder. This is now a valuableinstrument and the company can sell this to release cash. Thebuyer of the CD will receive the deposited money on maturityplus interest. Result: the bank has money deposited for a setperiod and the original lender can obtain cash by selling the CDat any time.

Treasury bills Sold by the government at a discount to face value to provide an effective yield. Tradeable in the secondarymarket.

Bank bills (acceptance credits)See Chapter 12

A bill of exchange accepted by a bank. The bank is committed to pay the amount on the bill at maturity. Acompany with surplus cash could invest in such a bill.

Local authority deposits Lending to a local authority (local government).

Discount market deposits A deposit normally repayable at call (on demand) or madefor very short term with a London discount house.

Gilts Purchase of UK government bonds, usually in thesecondary market.

Corporate bonds Secondary-market purchases of bonds issued by otherfirms.

Eurobonds, FRN, EMTN Lending on an international bond – see Chapter 11.

Commercial paper Unsecured promissory note: usually 60 days or less tomaturity.

Shares See Chapters 9 and 10.

Derivatives (futures, swaps,options, etc.)

See Chapter 21.

13 TREASURY AND WORKING CAPITAL MANAGEMENT Glen Arnold: Corporate Financial Management, Second...

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