COLLEGE OF ARTS SOCIAL AND MANAGEMENT SCIENCES (CASMAS)

DEPARTMENT OF ACCOUNTING, FINANCE & TAXATION

LECTURES TWO AND THREE

WORKING CAPITAL MANAGEMNT

3. INTRODUCTION TO WORKING CAPITAL MANAGEMNT

3.1 Definition, Concept and Component of Working Capital

Every business needs adequate liquid resources in order to maintain day-to-day cash flow. It needs
enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its
workforce and ensure its supplies. Maintaining adequate working capital is not just important in
the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the
business in the long-term as well. Even a profitable business may fail if it does not have adequate
cash flow to meet its liabilities as they fall due.
Working Capital is the fund required for day-to-day running of a business. It is the life blood of a
business organisation which must be maintained at an optimum level. It is a financial concept
describing the current assets and current liabilities of a business. It is the portion of current assets
financed by medium to long term funds.
There are two concepts of working capital and these are:
i. Gross working capital – This refers to the totality of the current assets of a business. It
is the company’s investment in current assets.
ii. Net working capital – This refers to the difference between current assets and current
liabilities of a business. The net working capital of a business may be positive or
negative.
Current assets are the assets that can be converted to cash within an accounting year. These include
cash, stock, short term securities, prepayments and debtors. Current liabilities are the claims of
persons external to the business which are expected to mature for repayment within one accounting
year. They include creditors, accruals and other bills payable.
Under the Net working capital concept, which is mostly adopted, working capital can be defined
as excess of current assets over current liabilities. The ideal ratio (current ratio) generally accepted
is 2:1, that is total current asset must be at least twice the total current liabilities while the ideal
quick ratio is 1:1, that is the total current asset excluding the value of stock must be at least equal

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to the total current liabilities. Quick ratio is the ratio of current assets less inventories to the current
liabilities. Although these ideal ratios may varied in practice depending on the industry and nature
of the trade of the company.
The objective of working capital management is to maintain an optimum level of the
components of working capital and this is purely a management decision. The optimum level is
affected by various factors which are:
3.2 Factors Affecting Working Capital

i. The fluctuations necessitated by seasonal sales, change in taste and fashion.

ii. The operating cycle affect the working capital, a long term operating cycle would result
into capital tie down and hence increased cost of working capital.
iii. The credit policy of' a company can impact either negatively or positively upon its
working capital. A liberal credit term will result in capital tie-up but a high level sales,
and hence high level, while a tight credit policy may reduce sales but improve liquidity.
Profitability may be low with high credit policy. Thus, the company must strike a
balance between liquidity and profitability.
iv. The growth stage of the company will affect working capital requirement. A new
growing company will require a high level of working capital and the working capital
cycle will be short and rapid.
v. Nature of business can also affect the working capital requirement.
vi. The variability in stock purchase due to the company’s speculation purchase.
vii. Production efficiency resulting from technology and manufacturing policy
viii. Availability of credit from suppliers
The amount of funds tied up in working capital would not typically be a constant figure throughout
the year and only in the most unusual of businesses would there be a constant need for working
capital funding. For most businesses there would be fluctuations ranging from week to month.
Some businesses operate in industries that have seasonal changes in demand, meaning that sales,
stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others.
In principle, the working capital need can be separated into two parts:
 A fixed working capital, and
 A fluctuating working capital
The fixed part is probably defined in amount as the minimum working capital requirement for the
year. The more permanent needs (fixed assets and the fixed element of working capital) should be
financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element
should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and
repaid easily and at short notice.

3.3 Working Capital Components and Working Capital Cycle

The components of working capital are the current assets and current liabilities as reflected in the
statement of financial position.

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Current assets, cash or near cash resources, are those assets which are convertible into cash within
a period of one year and are those which are required to meet the day-to-day operations of a
business. Current assets include the followings:
i. Cash and bank balances
ii. Short term investments
iii. Prepaid expenses
iv. Trade debtors and other receivables
v. Stocks of raw materials, work-in-progress and finished goods
Current Liabilities are those obligations and claims of outsiders which are expected to mature for
payment within an account year. Current liabilities include the followings:
i. Creditors for goods purchased (Trade Creditors)
ii. Short term borrowings (e,g. Bank overdraft)
iii. Taxes and dividend payables
iv. Accrued expenses (Accruals)
v. Other bills and liabilities maturing within a year

a. Working Capital Cycle Defined

The components of working capital are not permanent in its form throughout a year but rather
changes form from one component to another in that cycle over a period of time. Working Capital
Cycle (WCC) or Cash Operating Cycle (COP) is the length of time it takes for cash to be invested
in other components of working capital and turning back to its original form of cash in a continuous
cycle. It is the total period of time between the investing cash for procurement of raw material and
collection of cash from sales or debtors. For non-manufacturing concerns, it is starts from the time
when goods meant for resale are purchased to the time when cash was collected from the sales or
debtors. WCC reflects the ability and efficiency of a business to manage its short term liquidity
and it is also refer to as Cash Conversion Cycle.

Figure 3.1 – Working Capital Cycle

-*

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The longer this cycle, the longer a business is tying up resources in its working capital components
without earning any return on it and the faster a business can push items around the cycle, the
lower its investment in working capital will be. So one of the objectives of working capital
management is to reduce the WCC to the minimum possible. Working capital management focus
much on liquidity of the business. However a too strict policy on working capital management
may jeopardise profitability and as such a financial manager should strike a balance between
liquidity and profitability.

b. The concept of Overcapitalisation and Overtrading

A business is said to be overcapitalised if its working capital is excessive for its immediate need.
Excessive stocks, debtors and liquid cash will lead to return on investment with long term fund
tied-up in non-earning short term assets. Over capitalisation can normally be identified by poor
accounting ratios like liquidity ratios.
A business is said to be overtrading if it is trying to carry out too large volume of activities with
a low level of working capital. Overtrading is a serious problem that small but rapidly expanding
business can fall into.
To determine the WCC of a business, the holding, turnover or investment period of each
component within the cycle has to be determined. They are calculated as follows:
i. Raw Material Cycle or Raw Material Conversion Period – This is the period of time it
takes to turn raw material held in stock into production process and concert it to work-in-
progress.
𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑆𝑡𝑜𝑐𝑘
𝑅𝑀𝐶 = × 365 𝑑𝑎𝑦𝑠
𝑅𝑎𝑤 𝑀𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑

ii. Work-In-Progress Cycle or WIP Conversion Period – This is the period of time it takes
to convert raw material in production into finished goods.

𝑊𝐼𝑃 𝑆𝑡𝑜𝑐𝑘
𝑊𝐼𝑃𝐶 = × 365 𝑑𝑎𝑦𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑)

iii. Finished Good Cycle - This is the period of time it takes to sell the items produced or
purchased to customers.

𝐹𝑖𝑛𝑖𝑠ℎ𝑒𝑑 𝐺𝑜𝑜𝑑 𝑆𝑡𝑜𝑐𝑘

𝐹𝐺𝐶 = × 365 𝑑𝑎𝑦𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑

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 iv. Debtors Payment Cycle or Debtors Collection Period – This is the period of time it takes
debtors for good sold to repay for goods sold to them on credit. It is the average credit
period given to customers.
𝐷𝑒𝑏𝑡𝑜𝑟𝑠
𝐷𝑃𝐶 = × 365 𝑑𝑎𝑦𝑠
𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
v. Creditors Repayment Cycle or Creditor Repayment Period- This is the period of time
it takes the business to pay for raw material or goods purchased on credit. It is the average
credit period allowed by suppliers.

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
𝐶𝑅𝐶 = × 365 𝑑𝑎𝑦𝑠
𝐶𝑟𝑒𝑑𝑖𝑡 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠

vi. Working Capital Cycle or Cash Operating Cycle

𝑊𝐶𝐶 = 𝑅𝑀𝐶 + 𝑊𝐼𝑃𝐶 + 𝐹𝐺𝐶 + 𝐷𝑃𝐶 − 𝐶𝑅𝐶 (𝑑𝑎𝑦𝑠)

Note:
The shorter the cycle the better for a business
The cycle can also be computed in weeks or months
The numerators can be average for the period or end of period balance. The choice must
be consistently used for meaningful comparison.
 Where cost of production is not readily available for WIPC computation, cost of goods
sold can be used.
 For wholesale or retail business (Non-manufacturing concern), there will no RMC and
WIPC
 Only the credit portion of sales and purchases are considered for DPC and CRC i.e.
excluding cash sales/purchases.
Illustration 3.1
Below is the extract from the Statement of Comprehensive income of VVS Ltd for the year ended
30th June 2020. VVS manufactures 2 products, VeryVery and Simple, in its production line from
common raw materials.
N’000
Turnover (Including cash sales of N50m) 300,000
Cost of Sales 210,000
Purchases of raw material (All on Credit) 140,000
Raw material used in production 150,000
Other conversion costs 30,000

The following are also extracted from the Statement of Financial Position as at same date:

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Closing stock of Raw material 12,000
Closing stock of Finished products 25,000
Closing stock of goods under production 10,000
Trade debtors 12,500
Creditors for raw material purchased 15,000

Required: Compute the length of the working capital cycle in days.

Illustration 3.2

The Financial Manager of Keplaz Limited, Omo Randle, has obtained the following indices
concerning the average working capital cycle from their industry year book for the purpose of
evaluating the effectiveness of their working capital management.

Days
Raw material stock turnover 20
Credit day from Suppliers of raw material 40
Work-in-progress cycle 15
Finished goods stock turnover 40
Debtors Collection period 60
Net Operating working capital cycle 95

Using the data extracted from the books of Keplaz Limited, you are required to calculate the similar
indices as obtained for the industry and comment on them.

N’000
Sales 3,000
Purchases 600
Cost of Sales 2,000
Average raw material stock 80
Average work-in-progress 85
Average finished goods 180
Average Creditors 90
Average Debtors 350

3.4 Management Of Working Capital Components

1. MANAGEMENT OF STOCK OR INVENTORY

Inventory or stock in an organisation, especially a manufacturing concern, can be
 Stock of raw materials
 Stock of work-in-progress
 Stock of finished goods

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The main objective of stock management is to ensure sufficient and optimum levels of stock is
maintain to meet production and demand for finished goods while ensuring the total cost
attributable to maintaining stock is minimised. As excessive stock will tie-up capital and extend
the working capital cycle while inadequate stock will slow down production and sales, there is a
need to strike a balance a between these two seemingly confusing objectives.
The level of stock of these 3 stock items will depend on the nature of the business of the
organisation or motives behind stock policy. There are 3 general motives for holding stock.
i. Transaction motive – This motive centered on the need to hold or maintain stock ensure
smooth production and sales operations.
ii. Precautionary motive – The motive centered on the need to hold or maintain stock to guard
against fluctuation or risk of changes in demand and supply forces.
iii. Speculative motive – centered on the need to hold or maintain stock to take advantage of
price fluctuation.
Inventory is important to be well managed because it is the most illiquid component of working
capital and as such for a company to determine its liquidity by way of ratio, inventory must be
deducted.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑜𝑟 𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

In order to achieve the objective of stock management by ensuring the total cost of maintaining
stock is minimised, answers must be provided to these two questions:
 How much should be ordered?, and
 When should quantity be ordered?
The first question relates to the problem of determining the best or optimum quantity to order at a
time while the second arise because of the uncertainty in what time it will take suppliers to supply.
The optimum quantity to order that answer the first question is called Economic Order Quantity.

A. Economic Order Quantity Model (EOQ)

EOQ is the quantity of stock ordered or re-ordered each time that will minimise the annual total
cost of keeping the stock in store. This quantity is assumed to be the most economical quantity.
There are two quantitative costs associated with determining EOQ. These costs are
 Ordering cost – This includes all cost incurred in the process of placing an order till it is
received. Ordering costs are
o Cost of preparing requisition for the order
o Cost of placing the order

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 o Cost of transportation
o Cost of receiving, inspecting and storing
o Step-up cost (for stock of goods manufacture internally)

 Carrying or holding cost – This is the administrative cost incurred on stock kept or held in
store, It includes
o Cost of warehousing and cost of storage space
o Interest on the cost of capital tied-up
o Cost of insurance
o Cost of deterioration and obsolescence
o Clerical and administrative cost
Stock-out cost is another cost associated with maintaining stock which is an essential factor to
consider in stock control but this is difficult to estimate and as such is regarded as qualitative cost.
Assumption of EOQ model
The EOQ model is based on the following assumptions
 Demand/Usage quantity of the stock item is known and constant
 Cost per order is known and constant
 Carrying or holding cos per unit t is known and constant
 Price per unit of the stock item is known and constant
 The lead time or re-order period is known and constant

𝐷
𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = 𝑄 𝐶𝑜

𝑄
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 = Cc
2

D = Annual Demand or Usage; Co = Cost per Order; Cc = Carrying cost per unit; Q = Order Qty

Because the Ordering cost and the Carrying cost move in opposite direction, total cost is
minimised at the equilibrium point when the Ordering cost equals Carrying cost and the Quantity
ordered at that point is the most economical.

2𝐷Co
𝐸𝑂𝑄 = √
Cc

Aside the EOQ model, there are other systems or measures of controlling and managing stock or
inventory. These includes
 Two-bin System
 Single bin system
 Periodic review
 Control levels
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 B. Inventory Control Levels
Inventory control levels are various levels set for ensuring the objectives of inventory control of
ensuring availability of adequate inventory for production or sales operations and that cost of
keeping inventory is at minimum possible.
These control levels are determined as a function of the

rate of consumption per period,

the time taken between when an order is placed and when received –(Lead Time or
Reorder Period)
These control levels are:
i. Reorder Level (ROL) – This is the level at which a new order must be placed. It is
calculated as

Reorder Level (ROL) = Maximum Consumption Rate X Maximum Reorder Period

ii. Minimum Level – This is the lowest permissible level at which stock must not fall below.
It is calculated as
Minimum Level = ROL – (Normal/Average Consumption Rate X Normal/Average Reorder
Period
iii. Maximum Stock Level – This is the highest permissible level at which stock must not
rise above. It is calculated as :
Maximum Stock Level = ROL + ROQ – (Min. Consumption Rate X Min. Reorder Period)
iv. Average Stock Level – This is the statistical mid-point between the minimum and
maximum stock level. It is not a control level in the real sense. It is calculated as:
Average Stock Level = (Minimum Stock Level + Maximum Stock Level) / 2
Illustration 3.3
Oge Intellect Ltd is a retailer of Gucci cosmetics. The company has an annual demand of 30,000
packets. The packets are purchased for stock in lots of 5,000 and cost N12 per packet. Fresh
supplies can be obtained immediately, with ordering and transport costs amounting to N200 per
order. The annual cost of holding one packet in stock is estimated to be N1.20.
Required: Calculate
a) The Ordering Cost
b) The Holding Cost
c) The EOQ
d) Explain the difference between ROQ and EOQ, if any

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Illustration 3.4
The average annual consumption of a material is 18,250 units at a price of N36.50 per unit. The
storage cost is 20% of unit price and the cost of placing an order is N50. How much quantity is
to be purchased at a time?

Illustration 3.5
Two components A and B are used as follows:
Normal usage = 50 per week each
Re-order quantity = A- 300; B-500
Maximum usage = 75 per week each
Minimum usage = 25 per week each
Re-order period = A - 4 to 6 weeks; B - 2 to 4 weeks
Calculate for each component
(a) Re-order level; (b) Minimum level; (c) Maximum level; (d) Average stock level.

2. MANAGEMENT OF DEBTORS AND CREDITORS

When goods are sold on credit, the purchasing company enjoys a credit facility pending the time
the payment is made. When the purchasing company take advantage of the credit period there is a
cost for such opportunity, which is the discount forgone, as the selling company may have offer
some incentive for early payment in form of discount.
It is often found on credit sales invoice a term of credit sales such as “2/15 net 45”. This credit
policy means that “a cash discount of 2% will be given to the purchasing company when payment
is made within 15 days otherwise full payment is expected thereafter latest on day 45. Failure to
pay on the last credit day (day 45) will also amount to loss of goodwill by the purchasing company.
Although this cost is not easily quantifiable, but the effect can be noticed on the purchasing
company.
The purchasing company has the choice of taking the discount granted and pays 98% of the invoice
value or 100% at worst on day 45. Where the purchasing company decided to take full advantage
of the credit period of 45 day and forgo the discount, the discount forgone has an implied cost
which is calculated as:

2 365
( × ) × 100% = 𝟐𝟒. 𝟖%
98 30

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The effective discount rate is 24.8% per annum
A. Management of Debtors (Account Receivables)
Debtors or account receivables is very important to a business for the reason that it could impact
negatively to the liquidity of the firm. Debtor is a tied down capital which will affect the firm’s
ability to finance other current assets and as such it needs careful analysis and proper management.
Thus a sound credit policy is needed to achieve a good debtors’ management. Credit policy is the
set of principles on the basis of which a company determines who to sell to on credit and for how
long. The term credit policy is used to describe three decision variables on which a manager can
influenced. These are:
Credit Standards – These are the criteria to decide the types of customers to whom credit
sales could be offered to.
 Credit terms – These are the specified period of credit and other terms of payment by
customers. What incentive should be offered for prompt payment and what will be the
tolerable payment period.
 Collection efforts – This has to do with determining the actual collection period. Extended
period of time for making payments will leads to high investment in debtors and the lower
the collection period, the lower will be investment in debtors.
Objective of credit policy - The primary objective of credit policy is to maximised shareholders’
wealth through increase in sales which will leads to improved profitability. However, increase
sales will also require additional investment and costs. Therefore, a trade-off between increased
profit and incremental investment is required. A firm has the choice of either a lenient or stringent
credit policy. Lenient credit policy means selling to customers on very liberal terms while a
stringent credit policy means selling on credit on a selective basis to customers who have proven
credit worthiness. In real sense, most firms follow a credit policy that lies between lenient and
stringent. Credit Policy of the firm should be flexible enough to boost profitability of the firm. It
is also important to consider liquidity as the daily activities of the firm need cash realised from
sale to meet the needs for finance for the moment.
While additional sales tends to add to a firm’s operating profit, there are some cost associated to
incremental sale resulting from credit policy liberalization. These are:
 Production and selling costs,
 Administrative costs (credit supervision and credit collection costs), and
 Bad debt losses
Factors affecting Credit Policy
i. Competitors credit policy – The credit policy of the competitors in the industry is of great
importance when a firm is deciding on its credit policy. A competitor offering an attractive
credit facility will be more favourable to customers than another with a less attractive credit
facility in terms of tenor of maximum payment period.

ii. Nature of product and business – Aside credit been offered to facilitate receipt of cash to
meet other obligations, credit is also offered to attract more customers and increase sales

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 revenue. Companies dealing in products that does not have substitute or operating a
monopoly market is likely not to consider any credit policy.

iii. Trade-off between cost of financing debtors/bad debts and contribution from increased
sales – Where the principal objective of credit is to increase profit, a credit policy will give
much consideration to cost of financing the incremental debtors and the possible resulting
bad debts against the incremental contribution or profit resulting from the credit policy

Aside from the above factors that affect the formulation of credit policy, a company may also
consider specific criteria for granting credit to individual customers.

B. Management of Creditors (Account Payables)

Management of creditors is in most case outside the control of a company except that the company
has to consider the costs and benefits in term of discounts offered by supplier. This will depends
on the liquidity position of the company under the following scenarios. A
a. Company is liquid or having cash – Under this situation two options are available
i. Take advantage of discount and pay cash
ii. Ignore the discount, invest the cash in a short term assets and pay full at end of the
trade credit period.

b. Company is not liquid but can borrow short term fund from another source to pay supplier –
Here the options are:
i. Borrow short term fund to pay and enjoy discount, then repay the short term
financing at the end of the trade credit period
ii. Ignore the alternative source of short term finance and pay the supplier in full at the
end of the trade credit period.
These two scenarios with the two options each, is also open to the customers of the company
(Debtors) as the company will be their creditor.
The decision criteria will be based on the comparison of the effective annual discount rate
with the short term investment rate or the borrowing cost

Illustration 3.6
CLAVICDEB Limited, an associate company of ID KABASA Limited, is into manufacturing of
KABASA Carbonated water and just received an invoice from one of its suppliers of raw material
for N 10,000,000.00 with a credit term of “2/30 net 60”. CLAVICDEB expected that the company
will be liquid to meet the obligation during the discount period. There is available short term
investment which CLAVICDEB can invest short term funds in at 27% per annum.
1. You are to advise CLAVICDEB whether to take up the discount offered or not.

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 2. Assuming CLAVICDEB will not be liquid to meet the obligation during the discount
period of 30 days but it can borrow short term fund from its associate company, ID
KABASA Limited, at the rate 20% per annum. Advise CLAVICDEB whether it should
borrow to pay and enjoy the discount of pay full amount at end of the credit period of 60
days.

Illustration 3.7
CALEBITES Ventures is a distributors of a popular Fruit Juice which it usually sell to sub-
distributors on credit after proper credit evaluation of their credit status. There has not been issue
of default from the customers as they pay on due day in line with company’s credit term.
CALEBITES needs to improve its liquidity position and accelerate the cash inflow from the
customers by providing incentive inform of discount to facilitate prompt payment.
The current payment term is without any discount and customers are requested to pay latest 60
days after supply. A new credit term that will offer 3% discount to customers that can pay within
15 days of supply is been considered with the existing term of full payment latest 60 days.
Customers’ payment trend and agitation has make it known to CALEBITES Ventures that most
customers will embrace the new credit term. CALEBITES can get fund from alternative source to
bridge its liquidity gap at interest rate of 27%.
You have been contacted as the consulting finance manager to provide advice whether
CALEBITES should adopt the proposed credit term and offer the discount or bridge its short term
liquidity gap by getting fund from alternative source as indicated.

3. MANAGEMENT OF CASH
Cash has been considered as the most important element in working capital management because
is the most liquid component of working capital. Company’s effectiveness in managing cash
impacted on the position on other components of working capital. Cash management is the art of
managing a firm’s short-term resources to sustain its ongoing activities and to optimise its
liquidity. It refers to how a firm intends to identify its short-term cash position, make use of its
excess cash, and handle shortfalls in cash required to meet immediate needs. It involves striking a
balance between been having excess cash and not having enough cash. A loss making business
(unprofitable business) can survive in the short run and turn its fortune around over time. While
the effect of continuous loss making may takes time to manifest, liquidity problem manifest much
quicker and as such liquidity is mostly consider as a forefront primary and short run objective of a
firm. Bad cash management may leads to the inability to meet immediate obligations resulting in
dissatisfaction of the suppliers, unhappy employees and defaulting customers.
Cash management process can be viewed from the position of cash planning which involved cash
flow management and optimisation of cash level. Cash planning entails making forecast for future
cash needs for the purpose of effective running of the company with the primary objective of

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identifying period and amount of gaps in cashflows and preparing ahead for investment of
anticipated surplus or alternative source to meet the deficit.
Questions on cash management often arise as to why a company need to hold cash beyond its
immediate need. Companies hold cash, aside for the purpose of meeting the immediate day-to-day
needs for running of the business, to provide for contingencies and to forestall possible higher
finance cost in the near future.
Motives for Holding Cash
The motives for holding cash by a company are:
i. Transaction Motive – This is the motive to hold cash to continue doing the business in the
ordinary course. This includes the need to hold cash to pay good purchases, services
received, salaries and wages, dividend and taxes, and other operating expenses. Cash to
meet these transactions are usually from cash generated from ordinary course of business
which in most cases is from sales.

ii. Precautionary Motive – This is the motive to hold cash to meet contingencies arising
outside the ordinary course of business. Cash is held as precautionary measure to meet
unexpected emergencies. The amount held under this motive depends on the predictability
of cash flows and the ability to borrow at short notice.

iii. Speculative Motive – This is the motive arising from the need to take advantage of
opportunities that may arise with cash requirement. It includes investing in profit making
opportunities when one is available. Speculation may also involve predicting price of
changes in material or goods.

A. CASH BUDGETTING
Cash budgeting is a planning process that entails estimation of cash flows for a specific future
period. The process involves preparing a budget of expected or anticipated cash items for a time
over a period. A cash budget is a budget os future period. These cash inflows and outflows include
revenues collected, expenses paid, loans receipts and payments, and other transactions that involve
movement (increase/decrease) of cash. The budget can be for a short period of less than one year
or a long period of over a year.

Illustration 3.8
Wake-up Nigeria Limited produced the following information covering the period October 2019
to February 2020.
OCT NOV DEC JAN FEB
N’000 N’000 N’000 N’000 N’000
Sales 300,000 400,000 400,000 600,000 800,000
ACC 301 CORPORATE FINANCE DR. OLALEKAN AKINRINOLA 14
Purchases 300,000 320,000 360,000 400,000 500,000
Operating Expenses 20,000 24,000 24,000 26,000 30,000
Wages 30,000 32,000 36,000 40,000 50,000
Lease Rental 20,000 20,000 20,000 20,000 20,000
Rental Income 20,000 24,000 36,000 40,000 50,000

Additional information provided were as follows:

a. Payment for sales is 50% cash sales and 50% credit sales. The credit sales are paid for in
two equal installments commencing from a month after sales.
b. Purchases are paid for 40% in the month of purchases and the remaining are paid in the
following two months in equal installments.
c. Operating expenses: 50% are paid in the month incurred while the other 50% is deferred
by a month.
d. Wages and lease rentals are to be paid in due months.
e. Rental income is expected to be received as due.
You are required to prepare a cash budget for three months December 2019 to February 2020.

Illustration 3.9
The following details are forecasted by Caleb Mega Bakery Products Ltd for the purpose of
effective cash utilisation and management.
i. Estimated Sales and Costs:
Month Sales Flour & other Salaries & Other Overhead
Materials Wages Costs
=N= =N= =N= =N=
January 4,200,000 2,000,000 1,600,000 450,000
February 4,500,000 2,100,000 1,600,000 400,000
March 5,000,000 2,600,000 1,650,000 380,000
April 4,900,000 2,820,000 1,650,000 375,000
May 5,400,000 2,800,000 1,650,000 680,000
June 6,100,000 3,100,000 1,700,000 520,000

ii. Credit items:

 Sales – 20% of sales on cash basis, 50% of the credit sales are collected one month
after sales and balance the following month.
 Credit allowed by suppliers is 2 months

ACC 301 CORPORATE FINANCE DR. OLALEKAN AKINRINOLA 15

  Delay in payment of salaries & wages is half of a month and other overhead costs
is delayed for a month
iii. Interest on 12% debenture of =N=5,000,000 is paid half yearly in March and September.
iv. Dividend on investments amounting to =N=250,000 is expected to be received in March,
2020.
v. A new machinery will be installed in March 2020 at a cost of =N=4,000,000 which is
payable in 20 equal instalments from April 2020.
vi. Advance income tax to be paid in May 2020 is =N=150,000
vii. Cash balance on 1st March 2020 is expected to be =N=450,000 and the CMBP Limited
wants to keep the monthly cash balance around this figure. The excess cash balance, in
multiple of =N=’000 (thousands), is to be put in fixed deposit.
You are required to prepare a monthly cash budget for four months beginning from March 2020.
Ignore interest on Fixed Deposit

Banking Policy
Sometimes there may be a need for a company that collect large sum of cash on frequent basis to
determine how often should be taken to bank for lodgment into their account either to reduce
overdrawn amount or to invest the cash in short term securities. In this situation, a company may
be faced with banking options that need to be considered for adoption.

Illustration 3.10
ADELEKE Nig. Plc is into sale of petroleum products and the annual receipt is =N=1.456 billion
spread evenly over the 52 weeks of the year. However the pattern within each week is that the
daily rate of receipts of Mondays and Tuesdays is twice the receipts of Wednesdays, Thursdays
and Fridays.
Receipts for a week are usually banked weekly on Fridays and there is a need to consider this
practice. Options are either to bank receipts daily or twice a week on Tuesdays and Fridays. The
incremental cost of each banking is =N=4,000. ADELEKE always operates on bank overdraft at
an interest rate of 14% per annum with interest being charged daily on simple basis.
You are to advise ADELEKE on the best of the three available banking policies for banking daily
receipts. Please show the cost implication of each options that guide your advice.

Other Cash Management Techniques

1. Accelerated cash collection – This technique involves reduction in time interval between
when goods are sold or services rendered and when the maximum time customers are

ACC 301 CORPORATE FINANCE DR. OLALEKAN AKINRINOLA 16

 required to pay. It is achieve through review or introducing credit policy/terms to
customers. (See Illustration 3.7 - CALEBITES Ventures)

2. Maintenance of optimum cash level – Keeping of cash (inventory of cash) is similar to

keeping inventory of stock. As such companies attempts to minimise the sum of the cost
of holding cash (interest cost and returns on alternative investment) and the cost of getting
the cash (cost of converting marketable securities to cash, other transaction costs). This
model of determining the optimum cash balance is called the Baumol’s Model which
comes with the following assumptions
 Total cash requirement can be forecasted with certainty;
 Cash payments occurs evenly over the period of time;
 Opportunity cost of holding cash is known and does not change over time;
 Transaction cost for converting securities or near-cash items to cash is constant.

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