Topic 5: Working Capital Management

(CASH & INVENTORY MANAGEMENT)

By Dr. Wasim Abbas Shaheen

Course Instructor:
Dr. Wasim Abbas Shaheen
Assistant Professor - Finance
QASMS, QAU, Islamabad

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Learning Objectives
• Discuss the nature of working capital decisions
• Understand the importance and need for working capital in a
business
• Develop and implement cash management system

By Dr. Wasim Abbas Shaheen

• Develop and implement inventory management system
• Discuss strategies for current asset and liability management

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What is Working Capital Management?

By Dr. Wasim Abbas Shaheen

“The management of short term assets and short term
liabilities of a company are referred to as net working capital
management”.

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Working Capital Decisions
Collections and
Disbursements

Cash
Inventory
Concentration

By Dr. Wasim Abbas Shaheen

Working
Capital
Decisions
Receivables & Liquidity
Payables Management

Bank Relations
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Why do firms have working capital?

Time Delays

By Dr. Wasim Abbas Shaheen

• Service fee • Legal and other costs
• Potential loss against • Costs for
• Maintaining
price changes reorganization
inventory
• Offering credit
policies
Transaction • Reducing the float Bankruptcy
Costs Costs

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The importance of working capital

Size and Financial

Volatility Well-being

By Dr. Wasim Abbas Shaheen

Sales Important for
Growth smaller firms

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 PART 1

By Dr. Wasim Abbas Shaheen

LIQUIDITY AND CASH MANAGEMENT

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Liquidity Management

Liquidity is a function of current asset and liability levels and composition, and the
ability to raise cash when needed.

• Liquidity has two major aspects – ongoing liquidity and protective liquidity.
• Ongoing Liquidity: It refers to the inflow and outflows of cash through the firm
as the product acquisition, production, sales, payment and collection process

By Dr. Wasim Abbas Shaheen

takes place over time.
• It is a function of its Cash Conversion Cycle (CCC) i.e.
CCC = OC – APP
where
OC = AAI + ACP

Note: OC = Operating Cycle, APP = Average Payment Period, AAI = Average Age of
Inventory and ACP = Average Collection Period

• Protective Liquidity: It refers to the ability to adjust rapidly to unforeseen cash

demands and to have backup means to raise cash. 8
Cash Management
• Cash refers to currency and demand deposits.
• Cash management involves having the optimum amount of
cash in hand.
• The objective of cash management is to invest excess cash for

By Dr. Wasim Abbas Shaheen

a return while retaining sufficient liquidity to satisfy future
needs.
• Good cash management means:
• Knowing when, where, and how your cash needs will occur and
where your cash is at all times,
• Knowing what the best sources are for meeting additional cash
needs and being prepared to meet these needs when they occur.
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Factors Affecting Cash Management

Cash
management
policies
The
Current
probabilities
liquidity
of different
position

By Dr. Wasim Abbas Shaheen

cash flows

Factors
Affecting
Forecasted
short and long
Cash Management’s
liquidity risk
term cash flow Management preferences

The firm’s
Schedule of
ability to
debt maturity
borrow 10
Balance of Cash a Company should Hold

By Dr. Wasim Abbas Shaheen

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Short Term Cash Investment
• It includes savings accounts earning daily interest,
long term savings accounts and certificate of
Time
Deposits deposits.

By Dr. Wasim Abbas Shaheen

• These are portfolios of short term high grade debt
Money instruments such as government securities.
Market Funds

• These are those deposits which pay interest.

Demand
Deposits
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Types of Check Processing Delays

Processing Deposit
Mail Float
Float Collection Float
• Time required • Time it takes • Time required

By Dr. Wasim Abbas Shaheen

for a check to for a creditor for a check to
move from a to deposit the clear
debtor to a check after
creditor receipt
• “Lock Box” &
“Collection
Centers”
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 Examples 1
Crown Corporation obtains average cash receipts of Rs. 200,000
per day. It usually takes 5 days from the time a check is mailed
to its availability for use. How much amount is tied up by the
delay?

By Dr. Wasim Abbas Shaheen

Calculation:

5 days x Rs.200,000 = Rs.1,000,000

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 Example 2
It takes Tinman Corporation about 7 days to receive and deposit
payments from customers. Therefore a lockbox system is being
considered. It is expected that the system will reduce the float time to
5 days. Average daily collections are Rs.500,000. The rate of return is
12 percent.
How much reduction in outstanding cash balances will occur from

By Dr. Wasim Abbas Shaheen

implementing the lock system and what shall be the maximum
monthly charge for the company on such lock box?
Calculation:
2 days x Rs.500,000 = Rs. 1,000,000
The return that could be earned on these funds is:
Rs.1,000,000 x 0.12 = Rs.120,000
The maximum monthly charge the company should pay for this
lockbox arrangement is therefore:
Rs.120,000 = Rs.10,000
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 Example 3

By Dr. Wasim Abbas Shaheen

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 Example 4

By Dr. Wasim Abbas Shaheen

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 PART 2

By Dr. Wasim Abbas Shaheen

INVENTORY MANAGEMENT

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Types of Inventory

Raw • Material acquired from the

supplier which will be used in the
Materials manufacturing of goods

By Dr. Wasim Abbas Shaheen

Work in • These are partially completed
goods at the end of the accounting
Process period

Finished • These are completed goods

awaiting sale
Goods 19
Role of Financial Manager in
Inventory Management
Assess the adequacy of the raw materials level

Forecast the future price of raw materials

By Dr. Wasim Abbas Shaheen

Plan for a stock inventory balance

Examine the quality of merchandise received

Examine the degree of spoilage.

Manage proper inventory control system 20

Costs Involved in Inventory Management

Carrying
Cost
𝑄
CC= ∗ 𝐶
2
Total Cost

By Dr. Wasim Abbas Shaheen

TC = CC + OC
𝑄𝐶 SP
TC = +
Ordering 2 Q
Cost
S
OC = ∗ 𝑃 21
Q
Economic Order Quantity (EOQ)
• The EOQ is the optimum amount of goods to order each time
an order is placed so that total inventory costs are minimized.
2𝑆𝑃
EOQ =
𝐶

By Dr. Wasim Abbas Shaheen

• No of Order to be placed each Month:
The number of orders to be made for a period is the usage (S)
divided by the EOQ i.e.
S
No of Order to be placed each Month =
EOQ

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 Example 1
Winston Corporation needs to know how frequently to place their
orders. They provide the following information:
S = 500 units per month, P = Rs. 40 per order, C = Rs 4 per unit
2𝑆𝑃
EOQ =

By Dr. Wasim Abbas Shaheen

𝐶

2 500 (40) 40000

EOQ = = = 10000
4 4
= 100
The number of orders required for each month is:
500
No of Order to be made in each Month = = 5 orders
100
Therefore, an order should be placed after every 6 days approximately.
30
i.e. = 6 days. 23
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Reorder Point (RP)
The reorder point is that level of inventory on the basis of which
the timing of the economic order quantity is determined. When
the inventory reaches this level, the inventory should be
ordered.

By Dr. Wasim Abbas Shaheen

RP = Safety Stock + (Average Daily Usage * Lead Time)

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Factors Affecting the Level of
Current Assets

By Dr. Wasim Abbas Shaheen

The rate of
The nature of The stability
The size of increase (or
the firm’s of the firm’s
the firm decrease) in
business sales
sale

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 Aggressive versus Conservative Management

Characteristics for Aggressive Characteristics for Conservative

Strategy Strategy
• Assets • Assets
• Low levels of current assets, but • High levels of current assets
effectively and aggressively • Long cash conversion cycle
manage
• Lower expenses and • Higher expenses and lower

By Dr. Wasim Abbas Shaheen

higher revenue leading to
higher EBIT
• High-risk/high-expected return
strategy
• Liabilities
• High levels of current liabilities
• Short cash conversion cycle
• Lower interest costs if short-term
rates are lower than long-term
rates
• High-risk/high-expected return
strategy
revenue leading to lower EBIT
• Low-risk/low-expected return
strategy
• Liabilities
• Low levels of current liabilities
• Long cash conversion cycle
• Higher interest costs if long-
term rates are higher than
short-term rates
• Low-risk/low-expected return
strategy
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