WORKING CAPITAL

MANAGEMENT

Presenter: Dr. Samuel Kariuki

 Areas to be Covered;
 Working capital policy
 Management of cash
 Credit policy
 Inventory management
Introduction
 Gross working capital refers to total current assets and these are
those assets that can be converted to cash within an accounting year
e.g. stock receivables, cash short-term securities and so on.
 Net working capital refers to current assets less current liabilities.
 Current liabilities are those claims of outsiders which are expected
to mature for payment within an accounting year e.g. bank
overdraft, payables, short term loans, accruals etc.
 Management of working capital refers to management of cash,
receivables, inventory and current liabilities.
 Working capital might refers to the management of both current
assets and current liabilities involve 2 major decisions.
1. Target levels of each category (optional current assets).
2. How these assets will be financial.
 Optional Current Assets
 Optional investment in current assets i.e. liquidity
management is important because current assets are
non-earning assets.
 Current assets affect the firm’s financial risk.
 The consideration of the level of investment in current
assets should avoid two danger point’s i.e. excessive
and inadequate investment in current assets.
 Excessive investment in current assets impairs
profitability because idle cash earns nothing.
 Inadequate investment can threaten the solvency of the
firm if it fails to meet its current obligations.
 Financing Current Assets
 Current assets can either be financed by use of short-
term or long-term funds.
 For every firm, there is a minimum level of net working
capital that is permanent.
 The magnitude of current assets needed is not always
the same.
 It increases and decreases with time but this are always
a minimum level of current assets which is continuously
required by the firm to carry on its business
operational.
 This minimum level is referred to as permanent fixed
current assets.
Approaches to Financing Current Assets

 There are 3 main approaches to financing current

assets:
Matching/hedging approach.
Aggressive approach
Conservative approach.
Matching/Hedging Approach
 In this approach the firm adapts a financial plan
which involves the matching of the expected life of
the asset with the expected life of the funds used
such that short-term funds are used to finances
temporary assets and long-term funds for long-term
assets.
Aggressive Approach
 Under this approach, the firm uses more of short-
term funds in the financing mix such that short-term
funds are used to finance all short-term plus a
portion of permanent current assets.
 And long –term funds used to finance a part of
permanent current assets.
 A very aggressive firm may finance all its current
assets using short-term funds. This is especially the
case for small firms which have united access to
capital markets.
 Conservative Approach
 Under this approach, a firm uses more of its long-
term funds for financing its needs. The firm uses
long-term funds to finance fixed assets, permanent
current assets and a part of the temporary current
assets.
 A firm using this approach has low risk and low
return because it uses long-term funds to finance its
short-term needs. At times, the firm may have excess
liquidity which should be invested in marketable
securities.
 Determinants of Working Capital
Requirements of a firm
 Nature of the Firm: A trading firm will usually require more
working capital than a firm in the service industry e.g. a
supermarket and a law firm
 Size of the Firm: A larger firm would require comparatively more
working capital than a smaller firm.
 Business fluctuation : During times of high demand, affirm would
require higher levels of working capital as compared to periods of
low demand.
 Growth stage of the firm: a mature firm requires less working
capital than a firm in the infant stage.
 Availability of credit from suppliers affects accounts payable.
 The credit policy of the firm would affect accounts receivable.
 Working Capital Management
Strategies
 Working capital management interrelated goals:
1. How to accelerate the collection of cash
2. How to control cash disbursements
3. How the appropriate working balance is
determined
4. How to invest any temporary idle funds in interest
bearing marketable securities.
5. How to forecast and manage cash shortages.
6. Pay accounts payable as late as possible without
damaging the firm’s credit rating. The firm should,
however, take advantage of any favorable cash
discounts.
 Inventory management
 There are three types of inventory:
 Raw material
 Work-in-progress
 Finished goods.
 There are 4 types of costs associated with inventory
management:
 Holding (carrying) cost
 Ordering cost
 Purchase cost
 Stock out costs
Basic Inventory Management Model
2𝑑𝑐𝑜
 Q* =
𝑐ℎ
 Where;
 EOQ = economic order quantity
 d=annual demand
 c h = holding cost
 co = Ordering cost
 This is the economic order quantity model which helps to manage
inventory by minimizing the ordering and holding costs.
 Smaller inventories reduce holding or carrying costs but since smaller
inventories imply more request orders they therefore involve high
ordering costs.
 Illustration
 A company requires 2000 units of items costing shs.
50 each. Each order costs shs. 50 to prepare and
process and the holding cost is shs. 15 per unit p.a
and for storage costs of 10% of the purchase price.
 Required:

How many units should be ordered each time an

order is made
 Management of Cash
 Cash is the ready currency to which all liquid assets can be reduced.
The level of cash and money and marketable securities held by firms
is determined by the motives of holding them.
 Transaction Motive - This motive requires a firm to hold cash to
conduct its normal businesses e.g. purchases, wages and salaries and
other operating expenses taxes and dividends etc.
 Precautionary Motive - Balances held mainly in highly liquid
marketable securities to cater for unexpected demand for cash or
emergencies.
 Speculative Motive – A firm may want ready funds at hand to
quickly take advantage of any opportunities that may arise.
 Compensating balances Motive – Minimum bank balances
Optimal Cash Balance
 The optimal working balance occurs when total costs
(transaction costs plus opportunity cost) are at a
minimum.
 The 2 main cash management models are:
Baumol model
Miller Orr model
Baumol Cash Management Model

 The Baumol model is a deterministic model which

assumes certainty of variables.
 It considers cash management similar to an
inventory management problem.
 Thus the firm attempts to minimize the sum of the
costs of holding cash and the cost of converting
marketable securities to cash. (EOQ model in cash
management.)
Assumptions of Baumol model
 The firm is able to forecast its cash needs with
certainty.
 The opportunity cost of holding money is known and
constant.
 Transaction costs are known and constant.
 The firms’ cash payments occur uniformly over a
period of time.
 The firm incurs holding cost for keeping the cash
balance. It is an opportunity costs that is , the return
foregone on the marketable securities .
Baumol Model Formula
2𝑑𝑐
 Q* =
𝑖
 Where;
 Q = amount converted into cash by selling securities or
borrowing(Optimal size of cash transfer)
 D =Total cash outflow (demand) per period (year)
 c = Transaction costs of each sale of securities or
borrowing
 I = opportunity cost i.e. the cost of Holding cash rather
than investing it.
 Illustration
 A Company anticipates Sh.150 million in cash
outlays during the next year. The outlays are
expected to occur equally throughout the year. The
company’s treasurer reports that the firm can invest
in marketable securities yielding 8% and the cost of
shifting funds from marketable securities portfolio to
cash is Sh.7, 500 per transaction. Assume the
company will meet its cash demands by selling
marketable securities. Using the Baumol model
determine optimal size of the company’s transfer of
funds from marketable securities to cash.
 Miller Orr. Model
 This is a stochastic or a probabilistic model which
assumes uncertainty in cash management. It assumes
that the daily cash flows are uncertain and therefore
follow a trendless random walk. This model therefore
sets limits within which cash should be managed. These
limits are:
 An upper limit, which is the maximum amount of cash to
be held (H)
 Lower limit, which is the minimum amount of cash to be
held (assumed to be zero) (L)
 Return point, which is the target cash balance
considered optimal.(Z)
Miller Orr Formula
3 3𝑐𝛿 2
 𝑍= +L
4𝑖
 Where;
 Z- Return Point
 C- conversion cost
 𝛿 2 - variance of daily net cash flows
 i- Opportunity cost
 L- Lower cash limit

H= 3Z
 Illustration
 It costs ABCCompany Sh. 3,000 to convert
marketable securities to cash and vice versa; the
firm’s marketable securities portfolio earns an 8%
annual return. The variance of ABC Company’s
daily net cash flows is estimated to be Sh. 2,
700,000.
 Required

Determine the return point and the upper limit.

MANAGEMENT OF RECEIVABLES
 Account Receivables are amounts of money owed to a
firm by customers who have bought goods and services
on credit. Management of receivables aims at
determining the optimal level of investment in
receivables, which maximizes the benefits and minimizes
the costs of holding receivables.
 Economic conditions, competition, product pricing,
product quality and the firm’s accounts receivables
management policies are the chief influences on the
level of a firms accounts receivable.
 Of all these factors, the last one is under the control of
the finance manager.
RECEIVABLES Contd..
 As with other current assets, the manager can vary
the level of accounts receivable in keeping with the
trade-off between profitability and risk.
 The firm’s financial manager controls accounts
receivable through the establishments and
management of:
Credit policy, which is determination of
credit selection, credit standards and credit
terms, and
Collection policy.
 Cash Budget
 A cash budget helps ensure that an organization,
division, or department will have the cash necessary
to function throughout the budget period.
 The cash budget can be broken down into smaller
units—months or quarters, for example—within the
entire budget period to reflect changing cash flows.
Steps for Preparing a Cash Budget
1. Determine the beginning cash balance.
2. Add receipts.
3. Deduct disbursements.
4. Calculate the cash excess or deficiency.
5. Determine financing needed.
6. Establish the ending cash balance. The ending cash
balance for each period will include the receipts and
loans less the disbursements and financing costs. The
ending cash balance becomes the beginning cash
balance for the next period.
ILLUSTRATION ON CASH BUDGET
 The opening cash balance for Mawingu Ltd. on 1
January, 2016 was expected to be sh. 30,000. The
budgeted sales were as follows:
Month Sh.
November 80,000
December 90,000
January 75,000
February 75,000
March 80,000
 Analysis of records shows that debtors settle their
accounts according to the following:
60% Within the month of sale
25% The month following
15% The second month after sale
 Extracts from the purchases budget were as follows:

Month Sh.
December 60,000
January 55,000
February 45,000
March 55,000
 All purchases are on credit and past experience shows
that 90% are settled in the month of purchase and the
balance settled a month after. Wages are sh. 15,000
per month and overheads of sh. 20,000 per month
(including sh.5,000 depreciation) are settled monthly.
Taxation of sh. 8,000 has to be settled in February and
the company will receive settlement of an insurance
claim of sh. 25,000 in March, 2016.
 Required:
 Prepare a cash budget for January, February and
March, 2016 for Mawingu Ltd.
 End

Thank You