4

Cash management and

working capital finance

Learning objectives
On completion of this chapter you should be able to:

Syllabus
reference

Management of inventories, receivables, payables and cash (continued)

• Explain the various reasons for holding cash, and discuss and apply the C2(f)
use of relevant techniques in managing cash, including:
- preparing cash flow forecasts to determine future cash flows and cash
balances
- assessing the benefits of centralised treasury management and cash
control
- cash management models, such as the Baumol and the Miller-Orr
models
- investing short-term.

Determining working capital needs and funding strategies

• Describe and discuss the key factors in determining working capital C3(b)
funding strategies, including:
- the distinction between permanent and fluctuating current assets
- the relative cost and risk of short-term and long-term finance
- the matching principle
- the relative costs and benefits of aggressive, conservative and
matching funding policies
- management attitudes to risk, previous funding decisions &
organisation size.
4

Exam context
This chapter covers issues relating to liquidity and the finance of working capital, which are part
of Section C of the syllabus (Working capital management) and completes this syllabus section.
Like the previous chapter, this syllabus area is examinable in all sections of the exam and exam
questions won’t just involve calculations (eg in section C part of an exam question may ask you to
discuss types of working capital funding strategies or to explain the meaning of a numerical cash
flow analysis that you have performed).

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Chapter overview
Working capital finance

Cash management Mathematical models

Motives for holding cash Baumol

Cash flow forecasting Miller-Orr

Easing cash shortages

Managing cash surpluses

Working capital finance Treasury management

Asset types Functions

Aggressive financing strategy Centralised

Conservative financing strategy Decentralised

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 1 Cash management

PER alert
Performance objective 10 requires you to ‘prepare and monitor an organisation’s cash flow,
credit facilities and advise on appropriate actions’. This chapter covers the management of
cash and cash flow forecasts.

We saw in the previous chapter that working capital management has two main objectives:
(a) To increase the profits of a business
(b) To ensure su cient liquidity to meet short-term obligations as they fall due
This chapter mainly focusses on liquidity and covers the importance of cash flow management
and di erent strategies that can be followed to provide working capital finance

1.1 Motives for holding cash

There are three main motives for holding cash.

Transactions motive Precautionary motive Speculation motive

A business primarily needs to Cash may also be needed to Some businesses hold surplus
plan to maintain su cient meet unexpected occurrences cash to take advantage of
cash to meet its forecast (eg an unforeseen downturn attractive investment
transactions eg paying in sales, or disruption to opportunities if these arise.
suppliers, employees etc. production). For example, the opportunity
Cash requirements to cover This often means that a to take over another company
this motive can be planned business will arrange an at an attractive price.
using a cash flow forecast. overdraft facility, or short-
term investments which can
easily be converted into cash
(discussed in section 1.4).

However, holding cash (or near equivalents to cash) has a cost: the loss of profits which would
otherwise have been obtained by using the funds in another way. So, as ever, the financial
manager must try to balance liquidity with profitability.

1.2 Cash flow forecasting

Cash flow forecast: A detailed forecast of cash inflows and outflows incorporating both
KEY
TERM revenue and capital items.

Cash flow forecasts will be prepared continuously during the year and will allow a business to
plan how to deal with expected cash flow surpluses or shortages.

1.2.1 Format of cash flow forecast

A cash flow forecast will tabulate estimated future cash receipts and payments in such a way as
to show the forecast cash balance of a business at defined intervals. There is no ‘set’ format that
you are required to use but it is sensible to follow these guidelines:
(a) Have two separate sections, one for cash inflows and one for cash outflows
(b) Don’t reproduce the forecast separately for each time period (instead add a new column for
each time period being analysed)
(c) Finish each column by netting o the cash flow for the period and adding it to cash brought
forward to create a final cash flow carried forward figure. This can be done easily in the exam
using the spreadsheet functionality available in the constructive response workspace.

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 Here is an example of a cash forecast, illustrating a sensible format.

CASH FORECAST FOR THE THREE MONTHS ENDED 31 MARCH 20X1

January February March

Cash receipts
Sales receipts (W1) X X X
Issue of shares X
Cash payments
Purchase payments (W2) (X) (X) (X)
Dividends/Taxes (X)
Purchase of non-current
assets (X)
Wages (X) (X) (X)
Cash surplus/deficit for month X (X) X
Cash balance, beginning X X (X)
Interest on opening cash
balance X X (X)
Cash balance, ending X (X) X

Working

January February March

1. Timing of sales receipts
Revenue from sales 1 month ago (assuming 1- From Dec From Jan From Feb
month credit period) sales sales sales
2. Timing of supplier payments
Supplier invoices from 2 months ago (assuming From Nov From Dec From Jan
2-month credit period) purchases purchases purchases

Exam focus point

In the exam you will need to think carefully about the expected timing of receipts and
payments of cash during the period and whether a cost is a cash item eg depreciation.

Activity 1: Cash forecast

Ben is a wholesaler of motorcycle helmets. It is 1 January 20X2.

Credit sales in the last quarter of 20X1 were as follows:

Helmets
October 2,000
November 2,000
December 2,500

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 His credit sales in the first quarter will be as follows:

Helmets
January 3,000
February 5,000
March 4,500

Customers are given 60 days’ credit and the average selling price is $10, a price rise of $1 is
planned in February. His biggest customer, Mickster, is given a 2% discount for paying cash when
the sale is made. Mickster is planning to buy 150 helmets in January and 250 Helmets in March.
The sales to Mickster are in addition to those credit sales stated above.
Purchases (an average of 30 days’ credit) are $4 per helmet. Ben plans to buy in the helmets a
month in advance of selling them. Total overheads are $2,000 per month; this includes $400
depreciation and wages of $1,000. All other overheads are paid for after a credit period of 30
days.
Ben plans to inject a further $5,000 of his own money into the business in March to help to buy
non-current assets for $29,000. These assets will be depreciated over five years.
Opening cash flow is negative $4,550 which is close to Ben’s overdraft limit of $5,500.
Required
Prepare a monthly cash flow forecast for the first quarter of 20X2 and comment on your results.

Solution

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 1.2.2 Working capital movements
If a question provides you with operating cash flows and working capital movements, you may
be required to adjust the operating cash flows for the cashflow impact of working capital
movements to calculate monthly cash flows.
Taking the previous activity, if you had been given the operating cash flows in January as being
$17,270 and had been told that, during January receivables are forecast to increase by $10,000
(meaning that $10,000 of revenue is deferred to the next period), trade payables are forecast to
increase by $7,400 (meaning that $7,400 of cost is deferred to the next period) and inventory is
forecast to rise by $7,400 (incurring $7,400 of cost in this period); then the net cash flow in
January could be calculated as:

$
Original operating cash flows 17,270
Less increase in receivables (10,000)
Plus increase in payables 7,400
Less increase in inventory (7,400)
Net cash flow for January 7,270

Essential reading

See Chapter 4 Section 1 of the Essential Reading, available in the digital edition of the Workbook,
for further practice on this area.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

1.3 Methods of easing cash shortages

The steps that are usually taken by a company when a need for cash arises, and when it cannot
obtain resources from new sources of finance, could include the following:
(a) Delaying non-essential capital expenditure
Some new non-current assets might not be needed for the development and growth of the
business, but it may not be possible to delay some capital expenditures without serious
consequences.

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 For example, if a company’s policy is to replace company cars every two years, but the company
is facing a cash shortage, it might decide to replace cars every three years.
(b) Accelerating cash inflows which would otherwise be expected in a later period.
It might be possible to encourage credit customers to pay more quickly by o ering discounts for
earlier payment. This was covered in Chapter 3.
(c) Reversing past investment decisions by selling assets previously acquired
Some assets are less crucial to a business than others. If cash flow problems are severe, the option
of selling investments or property might have to be considered. Sale and leaseback of property
could also be considered.
(d) Negotiating a reduction in cash outflows to postpone or reduce payments
There are several ways in which this could be done:
• Longer credit might be taken from suppliers. Such an extension of credit would have to be
negotiated carefully: there would be a risk of having further supplies refused.
• Loan repayments could be rescheduled by agreement with a bank.
• Dividend payments could be reduced. Dividend payments are discretionary cash outflows,
however cutting the dividend is likely to be interpreted as sign of weakness by the financial
markets so this could be considered as a last resort.

1.4 Managing cash surpluses

If cash surpluses are only forecast for the short-term (eg due to seasonal factors) and will be
required to o set cash deficits in the near-future, then it will be important to invest these cash
surpluses in a way that minimises risk (because the funds will be needed soon).
Desirable investments would generally be low risk and liquid (ie easy to turn in to cash). These
could include:

Definition
Treasury bills Short-term government IOUs, can be sold when needed

Term deposits Fixed period deposits

Certificates of deposit Issued by banks, entitle the holder to interest plus principal, can be
sold when needed

Commercial paper Short-term IOUs issued by companies, unsecured

If cash surpluses are forecast for the long-term (eg due to seasonal factors) then a di erent
perspective can be taken. Long-term cash surpluses may be used to fund:
(a) Investments – new projects or acquisitions
(b) Financing – repay debt, buy back shares
(c) Dividends – returning funds to shareholders
These areas are covered in later chapters.

Essential reading

See Chapter 4 section 2 of the Essential reading, available in the digital edition of the Workbook,
for further discussion of this area.
The Essential reading is available as an Appendix of the digital edition of the Workbook.

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 2 Mathematical models
A number of di erent cash management models indicate the optimum amount of cash that a
company should hold.

2.1 Baumol model

The Baumol model is based on the idea that deciding on optimum cash balances is like deciding
on optimum inventory levels. It assumes that cash is steadily consumed over time and a business
holds a stock of marketable securities that can be sold when cash is needed. The Baumol model is
an adaptation of the EOQ model to manage cash.

Formula provided

2CoD
Economic order quantity =
Ch

The cost of holding cash (Ch) is the cost of obtaining the funds net of any interest earned by
investing the funds.
The cost of placing an order (Co) is the administration cost incurred when selling the securities.
The demand (D) is the annual cash required.

Illustration 1: Baumol approach to cash management

Finder Co faces a fixed cost of $400 to obtain new funds. It requires $240,000 of cash each year.
The interest cost on new finance is 12% per year and the interest earned on short-term securities is
9% per year.
Required
How much finance should Finder raise at a time?

Solution
The cost of holding cash is 12% – 9% = 3%
The cost of placing an order is $400
The annual demand is $240,000
Applying the EOQ formula, the optimum level of Q (the ‘reorder quantity’) is:

2 × 400 × 240,000
= $80,000
0.03
The optimum amount of new funds to raise is $80,000. This amount is raised three times every
year (240,000 ÷ 80,000).

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 Activity 2: Baumol model

A division requires $1.5m per year; cash use is constant throughout the year. Transaction costs are
$150 per transaction and deposit interest is generated at 7.5% and interest on short-term financial
securities is 12%.
Required
What is the optimal economic quantity of cash transfer into this division’s sub-account and how
frequently?
$1,500,000 once a year
$77,500, 19 times a year
$61,200, 25 times a year
$100,000, 15 times a year

2.1.1 Drawbacks of the Baumol model

(a) In reality, it is di cult to predict amounts required over future periods with much accuracy.
(b) It is unlikely that cash will be used at a constant rate over any given period (there will points
in time when cash out flows will spike as machinery is bought or an interest payment on a
loan is made etc).

2.2 Miller-Orr model

Another cash management model is the Miller-Orr model, which recognises that cash inflows and
outflows vary considerably on a day to day basis. This is clearly more realistic than the Baumol
model’s assumption of constant usage of cash during a period.
It works as follows:
(a) A safety level (lower limit) of cash is decided upon (often this will be imposed by a bank).
(b) A statistical calculation is completed to establish the upper limit (the maximum cash that will
be required) taking into account the variability in a firm’s cash flows. The di erence between
the lower and upper limits is called a spread, this is calculated using a formula (which is
given):
1
3 Transaction cost × Variance of cash flows 3
Spread = 3 ×
4 Interest rate
The upper limit = lower limit + spread
(c) The cash balance is managed to ensure that the balance at any point in time is kept between
the lower and upper limits.
If the cash balance reaches an upper limit (point A in the following diagram) the firm buys
su cient securities to return the cash balance to a normal level (called the ‘return point’).
When the cash balance reaches a lower limit (point B), the firm sells securities to bring the
balance back to the return point.

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 Cash A
balance Upper limit

The firm
buys securities

Return point

The firm
sells securities
Lower limit
B

0 Time

Formula provided
The return point is calculated as: Lower limit + (1/3 × spread)
This formula is also given.

Illustration 2: Miller-Orr

The following data applies to a company.

(1) The minimum cash balance is $8,000.
(2) The variance of daily cash flows is $4,000,000, equivalent to a standard deviation of $2,000
per day (note: standard deviation is the square root of the variance).
(3) The transaction cost for buying or selling securities is $50. The interest rate is 0.025% per
day.
Required
You are required to formulate a decision rule using the Miller-Orr model.

Solution
(1) The spread between the upper and lower cash balance limits is calculated as follows.
1
3 Transaction cost × Variance of cash flows 3
Spread = 3 ×
4 Interest rate
1
3 50 × 4,000,000 3
Spread = 3 ×
4 0.00025 =
1
11 3
3× 6× 10 = 3 × 8,434.33 = $25,303 say $25,300
(2) The upper limit and return point are now calculated.
Upper limit = lower limit + $25,300 = $8,000 + $25,300 = $33,300
Return point = lower limit + 1/3 × spread = $8,000 + 1/3 × $25,300
= $16,433, say $16,400

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 (3) The decision rules are as follows.
• If the cash balance reaches $33,300, buy $16,900 (= 33,300 - 16,400) in marketable securities.
• If the cash balance falls to $8,000, sell $8,400 of marketable securities for cash.

Exam focus point

Variance = standard deviation2 so if you are given the standard deviation, you will need to
square it to calculate the variance.
If you are given the annual interest rate, you will need to divide it by 365 to obtain the daily
interest rate.

2.2.1 Drawbacks of the Miller-Orr model

The usefulness of the Miller-Orr model is limited by the assumptions on which it is based:
• The estimates used (for example of variability) are likely to be based on historic information
which may unreliable as a predictor of future variability (for example if the economic or
competitive environment changes).
• The model does not incorporate the impact of seasonality: for example, for a retailer, seasonal
factors are likely to a ect cash inflows.

3 Working capital finance

As a business grows, its non-current asset and current asset base need to grow and this has
implications for financing. Here we consider di erent strategies for financing working capital.

Working capital finance: The approach taken to financing the level, and fluctuations in the
KEY
TERM level, of net working capital.

In order to understand working capital financing decisions, assets will be divided into three
di erent types.
(a) Non-current (fixed) assets
Long-term assets from which an organisation expects to derive benefit over a number of periods;
for example, buildings or machinery.
(b) Permanent current assets
The minimum current asset base (eg inventory, receivables) required to sustain normal trading
activity.
(c) Fluctuating current assets
The variation in current assets during a period, for example due to seasonal variations.

3.1 Working capital finance strategies

There are di erent ways in which long- and short-term sources of funding can be used to finance
current and non-current assets.
Chapter 9 will examine specific types of short- and long-term finance in more detail, here we
discuss some of the general characteristics of short- and long-term finance.

3.1.1 Long-term finance and short-term finance compared

Long-term finance is usually more expensive than short-term finance because investors require a
higher return for locking their money away for longer time periods.
However, long-term finance provides higher security to the borrower than short-term finance,
because there is no guarantee that short-term finance will be available to them when it is needed
in the future.

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 3.1.2 Aggressive and conservative working capital financing strategies
In the previous chapter we identified that working capital investment strategies can be
aggressive (low net working capital) or conservative (high net working capital).
Similar terminology exists when we discuss working capital financing strategies.

Aggressive financing strategy Conservative financing strategy

Minimal long-term finance for working High level of long-term finance for working
capital capital

Mainly uses cheaper short-term sources of Mainly uses more secure long-term sources
finance – short-term funds are used to of finance – long-term funds are used to
finance fluctuating current assets and a finance permanent current assets and a
proportion of permanent current assets. proportion of fluctuating current assets.
Leads to problems if short-term finance is not This strategy is safer but can be expensive
available when required. This strategy is
therefore risky

The following diagram relates these types of strategy to the investment in non-current assets and
current assets of a business.
The curved line represents the finance required at any point in time.
The dotted lines A, B and C are di erent possible levels of long-term finance, depending on the
working capital finance strategy being followed.
Assets above the relevant dotted line are financed by short-term funding while assets below the
dotted line are financed by long-term funding.
Assets ($)

A
Fluctuating
current assets
C

B
Permanent
current assets

Non-current
assets

0 Time

(a) Policy A is a conservative working capital finance strategy.

All non‑current assets and permanent current assets, as well as a significant part of the
fluctuating current assets, are financed by long-term funding.
At times when fluctuating current assets are low and total assets fall below line A, there will be
surplus cash which the company will be able to invest in marketable securities.
(b) Policy B is an aggressive working capital finance strategy.
All fluctuating current assets all financed out of short-term sources, and also some of the
permanent current assets. Minimal long-term finance is used.
(c) Policy C is a matching (or moderate) approach.
A balance between risk and return is achieved by policy C, a policy of maturity matching in
which long-term funds finance permanent assets while short-term funds finance non-permanent
assets. This means that the maturity of the funds matches the maturity of the assets.

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 Exam focus point
Be careful not to confuse working capital investment and working capital financing
strategies. The amount of working capital that a company chooses to have is an investment
decision whereas the type of financing it uses for its working capital is a financing decision.
In exam questions, many students do not demonstrate knowledge of the conservative,
aggressive and matching approaches to working capital financing.

3.2 Choice of working capital finance strategy

The working capital finance strategy that is most appropriate to a company depends on
(a) Management attitude to risk – short-term finance is higher risk to the borrower because it
may not be available in the future when needed. For example, it may not be possible to
access trade credit from suppliers when it is required.
(b) Strength of relationship with the bank providing an overdraft – if strong this will encourage
the use of short-term finance as it makes it more likely that a bank overdraft will be available
when required to provide short-term finance.
(c) Ability to raise long-term finance – if this is weak (perhaps because the organisation is small
and/or has not used long-term finance wisely in the past) this will mean there is a greater
need to use short-term finance because long-term finance is hard to access.

4 Treasury management
The responsibility for arranging short- and long-term finance is part of the responsibility of the
Treasury department.

4.1 Functions of treasury management

Treasury management normally has four functions

Liquidity Risk
management management

Treasury
management

Funding Corporate
finance

4.1.1 Liquidity management

This is the short-term management of cash that we have referred to at the start of this chapter.
The aim is to ensure that a company has access to the cash that it needs but does not hold
unnecessarily high levels of cash and does not incur high costs from needing to organise
unforeseen short-term borrowing.

4.1.2 Funding
This involves deciding on suitable forms of finance and organising suitable bank and capital
market debt.
Sources of finance will be covered in Chapter 9.

4.1.3 Corporate finance

This is the examination of a company’s financial strategies. For example, is the capital structure
appropriate, how are investments appraised, and how are potential acquisitions valued?
These areas are all covered in later chapters.

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 4.1.4 Risk management
This involves understanding and quantifying the risks faced by a company.
In this exam the main focus is on currency risk and interest rate risk (covered in Chapters 14 and
15).

4.2 Centralisation of treasury management

Within a centralised treasury department, the treasury department is normally based at Head
O ce and acts as an in-house bank serving the interests of the group.
This has a number of advantages compared to the alternative of allowing each division to
organise their own (decentralised) treasury operations:

Advantages of centralisation
Economies of scale Borrowing required for a number of subsidiaries can be
arranged in bulk (meaning lower administration costs and
possibly a better loan rate), also combined cash surpluses
can be invested in bulk.

Improved risk management Foreign exchange risk management is likely to be improved

because a central treasury department can match foreign
currency income earned by one subsidiary with expenditure
in the same currency by another subsidiary. In this way, the
risk of losses on adverse exchange rate movements can be
avoided without incurring the time and expense in managing
foreign exchange risk.

Reduced borrowing Cash surpluses in one area can be used to match to the cash
needs in another, so an organisation avoids having a mix of
overdrafts and cash surpluses in di erent localised bank
accounts.

Lower cash balances The centralised pool of funds required for precautionary
purposes will be smaller than the sum of separate
precautionary balances which would need to be held under
decentralised treasury arrangements.

Expertise Experts can be employed with knowledge of the latest

developments in treasury management.

However, some companies prefer to decentralise treasury management because:

(a) Sources of finance can be diversified and can match local assets.
(b) Greater autonomy can be given to subsidiaries and divisions because of the closer
relationships they will have with the decentralised cash management function.
(c) A decentralised treasury function may be more responsive to the needs of individual
operating units.

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