Revise Lecture 22

Revise Lecture 22

• Objectives of working capital?

• Cash operating cycle?

• Overtrading?

Objectives of WC Management

The two main objectives of working capital management are:

1. To increase the profits of a business

2. To provide sufficient liquidity to meet short term obligations as they fall due

Cash Operating Cycle

• The cash operating cycle also known as the working capital cycle is the period of the time between the outflow of cash to pay for raw material and the inflow of cash from customers.

• The cash operating cycle can be used to determine the amount of cash needed at any sales level and to identify the possibility of a cash short fall if sales rise too rapidly using the sales / net working capital ratio

Overtrading

• If a business fails to plan how to supply its forecast level of cash flow need, it will be in danger of overtrading.

• Overtrading is where a business has inadequate cash to support its level of sales.

Cash

• The Management of cash?

The Management of Cash

• As business grows, its working capital funding needs to also grow. A key question for a treasury department is how to fund this working capital growth.

• This is complicated by the fact that some current assets are permanent e.g. a certain amount of stock and debtors are always present and some are fluctuating due to seasonal fluctuation in business

The Management of Cash

Reasons for holding cashBusiness need to keep a certain amount readily available. The reasons include;1. Transaction motive2. Finance motive3. Precautionary motive4. Investment motive

The Management of Cash

Transaction Motive• Cash required to cover day-to-day expenses,

e.g. payroll, payment of suppliers etc

Finance Motive• Cash required to cover major items such as

the repayment of loans and the purchase of non-current assets

The Management of Cash

Precautionary motive• Cash held to give a cushion against unplanned

expenditure (the cash equivalent of buffer stock)

Speculative motive• Cash kept available to take advantage of

market investment opportunities

The Management of Cash

Running out CashThe cost of running out of cash can have serious operational repercussions;1. Settlement discounts for early payment are unavailable2. Trade suppliers refuse to offer credit, charge higher

prices or downgrade the priority with which orders are processed

3. If wages are not paid on time, industrial action may well result, damaging production in the short-term and relationships.

The Management of Cash

Cash Forecasts and Cash BudgetsCash ForecastsA cash forecasts is an estimate of cash receipt and payments for a future period under existing conditions

Cash BudgetsA cash budget is commitment to a plan for cash receipts and payments for a future period.

Cash Management Models

Cash management models are aimed at minimizing the total costs associated with movements between;

• A current account (very liquid but not earning interest)

• Short-term investments (less liquid but earning interest)

Cash Management Models

Mathematical ModelsThe models are devised to answer the questions;

1. At what point should funds be moved?

2. How much should be moved in one go?

Cash Management Models

There are two mathematical models that you need to be aware of:

1. Baumol’s model

2. Miller-Orr’s model

Cash Management Models

Baumol Model (The Baumol cash management model)

Baumol noted that cash balances are very similar to inventory levels and developmed a model based on the economic order quantity (EOQ) The model suggests that when interest rates are high, the cash balance held in non-interest bearing current accounts should be low.

Cash Management Models

• The Baumol model is an adaptation of the EOQ model to manage cash. It assumes that cash is used at a steady rate during the year, which will often not be the case.

• The Economic Order Quantity of Cash = 2*annual cash required*cost of ordering cash/Net interest cost of holding cash

Cash Management Models

• The formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at one time.

• Cash management model indicate or idea that optimum amount of cash or optimum cash balances that a company should hold and suggests optimum amount to be transferred regularly from investments to current account

Cash Management Models

Example:A division requires Rs1.5m per year, cash use is constant throughout the year.Required:What is the optimal economic quantity of cash transfer into this division’s sub account if ordering costs are Rs150 per transaction and the interest lost on the funds transferred is 4.5% pa?

Solution

Cash Management Models

Assumptions• Cash use is steady and predictable• Cash inflows are known and regular• Day-today cash needs are funded from current

account• Buffer cash is held in short-term investments

Miller-Orr-model – Cash management

• Another cash management model is the Miller-Orr-model which recognize that cash inflows and outflows vary considerably on a day to day basis (unlike the Baumol model).

• This is clearly more realistic.• The Miller-Orr model controls irregular

movements of cash by the setting of upper and lower limits on cash balances.

Miller-Orr-model – Cash management

Formulas Miller-Orr model

1. Spread

2. Upper limit

3. Return Point

Formulas

Miller-Orr model - Example

The minimum cash balance of Rs20,000 is required at Miller-Orr company and transferring money to or from the bank costs Rs50 per transaction.Inspection of daily cash flows over the past year suggests that the standard deviation is Rs3000 per day and hence the variance (SD squared) is Rs9million. The interest rate is 0.03% per day.

Miller-Orr model - Example

Required:1. The spread between the upper & lower limits

2. The upper limit

3. The return point

Solution

Solution

Cash Management

• How to managing cash flow surpluses?

• How to managing cash flow shortages?

• What is the role of treasury management?