Working Capital Management Cash Management

WORKING CAPITAL MANAGEMENT – CASH MANAGEMENT
 Importance of Cash
 Basic Principles of Cash Management
 Tools in Cash Management
 Cash Conversion Cycle
 Playing with the Float
 Cash Budget
 Baumol’s Optimum Cash Balance
 Cash Management Techniques
 Speeding up Collections
 Deferring Cash Payments/Outflows
IMPORTANCE OF CASH
 In an ordinary person’s viewpoint, cash is considered important as it facilitates
trade or exchange in the market. In a more detailed perspective, cash is deemed
important because it satisfies the following motives:
1. Transactions motive: this motive pertains to the use of cash to finance the
cash needs in the ordinary course of business *support operations (regular usage)
2. Precautionary motive: this motive pertains to the use of cash to safeguard
the company from contingencies *emergency purposes
3. Speculative motive: this motive pertains to the use of cash to take on
potential profit taking activities *investments
BASIC PRINCIPLES OF CASH MANAGEMENT *same to the principle of working capital

management *if cash is excessive, it protects from illiquidity, meaning it is very liquid, but at the expense
of profit
*up – cash; up – liquidity; down – profitability *the higher the working capital, the higher the liquidity, but
the lower profitability
*down – cash; down – liquidity; up – profitability *the lower the working capital, the lower the liquidity, but
higher the profitability
*cash – most liquid asset; readily available for payment; generate zero or minimal return
 One of the basic components of working capital is cash. As such, cash

management is one of the most important components of working capital
management. Consistent with the principle of self-liquidating debt, holding too
much liquidity by holding excess cash protects the company from possible
illiquidity at the expense of profit. On the other hand, being deficient in liquidity by
holding low amount of cash increases the company’s profitability at the expense
of liquidity. As such, companies are concerned regarding the optimum amount of
cash to be maintained to:
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a. have sufficient protection against illiquidity; and
b. maximize profitability.
 In connection with the basic principle of having sufficient protection against
illiquidity and maximizing profitability, we can extract the following objectives:
a. Holding or generating enough cash to meet payment requirements; and
b. Maintaining cash balance at the minimum to maximize profitability.
To attain objectives (a) and (b), companies must be able to manage its cash inflow and
outflows in order to meet payment requirements 5*liquidity and to maintain cash balance
at the minimum *profitability.
TOOLS IN CASH MANAGEMENT

A. Cash Conversion Cycle
B. Playing with the Float
C. Cash Budget
D. Baumol’s Optimum Cash Balance

– Cash Conversion Cycle *from purchase to sell – Days Sales Inventory *from sell to collection –
Days Sales Outstanding * DSI + DSO is Operating Cycle *how can operating cycle be relevant? *from
purchase to pay – Days Payable Outstanding
*DSI + DSO = Operating Cycle
*purchase ----- sell = DSI *sell ----- collect = DSO
purchase ----- sell ----- collect
purchase ----- pay ----- sell ----- collect
*purchase ----- pay = Days Payable Outstanding
*payment = cash outflow
*collection = cash inflow
*pay ----- sell ----- collect = Cash Conversion Cycle
 Cash conversion cycle pertains to the number of days inventories are sold,
receivables are collected, and payables are paid. Note that the firm’s cash
conversion cycle suggests the number of days required to convert noncash
current assets into cash in time to pay currently maturing obligations.
𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 𝐶𝐶𝐶 = 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑆� + 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠
𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛� 𝐷𝑆� − 𝐷𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛� (𝐷𝑃�) *the lower, the better
 Days sales in inventory – period of conversion of inventory to sales *the
lower, the better
 Days sales outstanding – period of collection of receivables *the lower, the
better
 Days payable outstanding – period of payment of accounts payable *the
higher, the better
 In relation to the findings given above, a reasonable manager would want to:
1. Speed up sales and minimize inventory period
2. Speed up collection and minimize collection period
3. Slow down payment and maximize payment period
*Cash is king *we want inflow but not outflow
𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 𝐶𝐶𝐶 = 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑆� + 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛� 𝐷𝑆� −
𝐷𝑎𝑦𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛� (𝐷𝑃�)
�𝑝𝑒𝑟𝑎𝑡𝑖𝑛� 𝑐𝑦𝑐𝑙𝑒 = 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑖𝑛 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝐷𝑆� + 𝐷𝑎𝑦𝑠 𝑠𝑎𝑙𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛� 𝐷𝑆�
𝐶𝑎𝑠ℎ 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑐𝑦𝑐𝑙𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐷𝑎𝑖𝑙𝑦 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜� × 𝐶𝐶𝐶

– Playing with the Float
 Float is the time required for written checks to be converted to “useable” cash.
The components of total float are the following:
1. Mail Float – the time required for written checks *from customers to be received
by the company
2. Processing Float – the time required for received checks to be processed by
the company and become ready for deposit
3. Transit/Clearing Float – the time required for the deposited check to clear
through the banking system and become available for use by the company.
 General classifications of float
1. Collections/Availability Float – “negative” float; minimize
2. Disbursements Float – “positive” float; maximize

– Cash Budget
 Cash budget gives companies the idea of its cash requirement for a certain
period of time (including necessary financing requirement).
– Baumol’s Optimal Cash Balance *William Baumol
 It computes the optimal cash balance (OCB) where the cost to hold cash
(foregone interest income) is equal to the cost to sell marketable securities
(convert short-term investments into cash). It is a re-modelled economic order
quantity (EOQ) formula used in inventory management. Optimal cash balance is
also called economic cash quantity (ECQ) or economic conversion size.
 Assumptions of Baumol’s model:
1. Cash: you either 1) hold it or 2) invest it.
2. Interest rates are constant.
3. Transaction cost is constant.
4. Cash usage is constant.
 Cost of cash
1. Opportunity/holding/carrying cost
− Cost to hold cash (foregone interest income)
2. Conversion/transaction cost
− Cost to sell marketable securities (convert short-term investments into
cash)
Opportunity cost =Average cash balanc e ( Q2 ) x Opportunity rate( O)

*Opportunity cost is also called carrying/holding cost
*If we have safety stock, just add it to average cash balance
Transaction cost=Number of transaction s ( UQ ) x Cost per transaction(C )

CU 2
Economic cash quantity ECQ=
√ O
*ECQ = Q
Where:
Q = cash quantity / conversion quantity U = annual cash usage
O = opportunity rate / interest rate C = conversion cost / cost per transaction
 Cash management techniques revolve in speeding up cash collection, deferring
cash disbursements, and synchronizing cash inflows and outflows.
1. Speeding up collections
a. Lockbox arrangement
b. Preauthorized checks
c. Concentration banking and depository transfer checks
d. Automated depository transfer check
e. Wire transfers
2. Deferring cash payments/outflows
a. Zero balance accounts
b. Maximization of credit terms
c. Payable through drafts
EXERCISES
– Motives of Holding Cash
A certain individual has P200,000 in cash. Based on his budget, P100,000 shall be
allocated for daily
expenses and tuition fees; P40,000 shall be allocated as part of reserves, and P60,000
shall be allocated for potential dollar investments.
a. How much cash is used to satisfy the transactions motive?
b. How much cash is used to satisfy the precautionary motive?
c. How much cash is used to satisfy the speculative motive?
– Basic Characteristics of Cash
Pilipin Island only has two banks in its territory namely Bank A and Bank B. Their
yearend internal reports asof December 31, 2020 showed the following condensed
information:
a. Suppose there has been no withdrawal in January, how will you comment on
Bank A and Bank B?
b. Suppose there has been P50, 000 will be withdrawn by depositors in January,
how will you comment on Bank A and Bank B?
c. Comment on the general characteristic of cash.
– Opportunity Cost of Cash

Compute the opportunity cost of cash for each of the following independent cases:
a. Starting with a cash balance of P10 billion (without any withdrawals during the
year) if it can be invested at a daily interest rate is 0.03%?
b. Starting with a cash balance of P10 billion (with P5-billion withdrawals in the
middle of the year) if it can be invested at a daily interest rate is 0.03%?
c. Starting with a cash balance of P10 billion (with P1-million withdrawals daily) if it
can be invested at a daily interest rate is 0.03%?
– Cash Conversion Cycle

Consider the three companies being analyzed with different cash receipts pattern and
cash payments pattern.
a. Company A – It sells inventory within 15 days on account, collects after 20 days
but pays suppliers after 10 days.
b. Company B – It sells inventory within 2 days on account, collects receivables
after 1 day and pays suppliers after 10 days.
c. Company C – It sells inventory within 2 days on account, collects after 1 day and
pays suppliers after 3 days.
Assume all of these companies started with zero assets, which of the following
companies will most likely suffer liquidity risk?
– Cash Conversion Cycle
You have recently been hired to improve the performance of Multinational Corporation,
which has been experiencing a severe cash shortage. As one part of your analysis, you
want to determine the firm’s cash conversion cycle.
The firm spends P19,800,000 on operating cycle investments each year, at a constant
rate.
Using the information above and a 360-day year,
a. Operating Cycle
b. Cash Conversion Cycle
c. Cash Conversion Cycle Investment
– Float Management
Consider the following companies:
Company A: Receipts are by check taking 3 days to clear. Payments are by check
taking 3 days to clear.
Company B: Receipts are by check taking 2 days to clear. Payments are by check
taking 1 day to clear.
Company C: Receipts are by check taking 1 day to clear. Payments are by check taking
3 days to clear.
Assuming all companies receive P10,000,000,000 daily and pays P10,000,000,000
daily and daily interest is 0.03%, how will the clearing days affect the profit of:
a. Company A
b. Company B
c. Company C
– Float Management
On an average day, a company writes checks totalling P2,500,000. These checks take 8
days to clear. The company receives checks totalling P2,100,000. These checks take 5
days to clear. The cost of debt is 10%. What is the firm's availability (collections) float?
What is the firm’s disbursement float? What is the firm’s net float? How much is the
profit due to the float situation?
– Optimal Cash Balance

Suppose that the interest rate on Treasury bills is 6%, and every sale of bills costs P20.
You pay out cash at a rate of P400,000 a month.
According to Baumol's model of cash balances,
a. How much is the optimal cash balance?
b. How much is the average cash balance? How much is the carrying cost?
c. How many times a month should you sell bills? How much is the conversion
cost?
d. Assuming a safety cash balance of P5,000, compute your answer in letter b and
c?
e.
– Optimal Cash Balance
Suppose that the interest rate on Treasury bills is 6%, and every sale of bills costs P20.
You pay out cash at a rate of P400,000 a month.
According to Baumol's model of cash balances,
a. How much is the optimal cash balance?
b. How much is the average cash balance? How much is the carrying cost?
c. How many times a month should you sell bills? How much is the conversion
cost?
d. Assuming a safety cash balance of P5,000, compute your answer in letter b and
c?
– Lockbox System
Kismo Co. is a manufacturing company that uses a centralized system that requires all
checks to be sent to its regional headquarters. An average of 5 days is required for
mailed checks to be received, 4 days for Kismo to process them and 1½ days for the
checks to clear through its bank. A proposed lockbox system would reduce the mail and
process time to 3 days and the check clearing time to 1 day. Kismo has an average
daily collection of P200,000. Kismo has the capacity to invest in marketable securities
that can earn 7.2%.
a. How much is the savings per transaction?
b. How much is the annual savings?
– Lockbox System
Banco De Ara has offered to set up and operate a lock box system for your company.
Details are given below. Estimate the annual savings. How much is the minimum bank
charge for us to accept the system?
Assume 360 processing days per year.
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WORKING CAPITAL MANAGEMENT – CASH MANAGEMENT

BASIC PRINCIPLES OF CASH MANAGEMENT *same to the principle of working capital

 One of the basic components of working capital is cash. As such, cash

TOOLS IN CASH MANAGEMENT

TOOLS IN CASH MANAGEMENT

*DSI + DSO = Operating Cycle

*purchase ----- sell = DSI *sell ----- collect = DSO

purchase ----- sell ----- collect

purchase ----- pay ----- sell ----- collect

*purchase ----- pay = Days Payable Outstanding

*payment = cash outflow

*collection = cash inflow

*pay ----- sell ----- collect = Cash Conversion Cycle

TOOLS IN CASH MANAGEMENT

TOOLS IN CASH MANAGEMENT

TOOLS IN CASH MANAGEMENT

Opportunity cost =Average cash balanc e ( Q2 ) x Opportunity rate( O)

Transaction cost=Number of transaction s ( UQ ) x Cost per transaction(C )

– Basic Characteristics of Cash

– Opportunity Cost of Cash

– Cash Conversion Cycle

– Cash Conversion Cycle

– Optimal Cash Balance

Assume 360 processing days per year.

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purchase ----- sell = DSI sell ----- collect = DSO