Financial Management |1
Working Capital Management
Introduction
Working Capital Management
deals with a firm's current assets and liabilities.
 Cash
 Accounts Receivable
 Inventory
Float and Cash Management
The basic objective in cash management is to keep the investment in
cash as low as possible while still operating the firm's activities
efficiently and effectively. This goal usually reduces to the dictum,”
Collect early and pay late.”
Reasons for Holding Cash
 Speculative and Precautionary Motives – the need to hold
cash to take advantage of additional investment, such as
bargain purchases. It is also the need hold cash as a safety
margin to act as a financial reserve.
 Transaction Motive – the need to hold cash to satisfy
normal disbursement and collection activities associated
with a firm’s ongoing operations.
Benefit and Opportunity Cost of Holding Cash
When the firm holds cash in excess of some necessary
minimum, it incurs an opportunity cost. The opportunity cost of
excess cash (held in currency or bank deposits) is the interest
income that could be earned in the next best use, such as investing
in marketable securities.
Understanding Float
Float – the difference between book cash and bank cash,
representing the net effect of checks in the process of clearing.
 Disbursement Float – checks written by a firm generate
disbursement float, causing a decrease in the firm’s book
balance but no change in its available balance.
A paid the supplier 20,000 by issuing a cheque which is yet to be
cleared. A's bank balance is 70,000. After the issuance of check, the
book balance of A is reduced to 50,000.
Disbursement Float = Firm's available balance – Firm's book balance
Disbursement Float = 70,000 – 50,000
Disbursement Float = 20,000
 Collection Float – checks received by firm create collection
float. Collection float increases book balances but does not
immediately change available balances.
A received a cheque worth 10,000 from customer. This cheque is not
yet deposited in the bank. The current bank balance of A is 60,000.
But as per book, the cash balance is 70,000.
Collection Float = Firm's available balance – Firm's book balance
Collection Float = 60,000 – 70,000
Collection Float = -10,000
 Net Float – the sum of the total collection and disbursement
floats. The net float at any point in time is the overall difference
between the firm’s available balance and its book balance.
Positive Net Float - means disbursement float exceeds its
collection float and its available balance exceed its book
balance.
Negative Net Float – means available balance is less than book
balance.
A received a cheque worth 10,000 from customer. This cheque is not
yet deposited in the bank. A paid the supplier 20,000 by a cheque
which is yet to be cleared. The cash balance per book is 100,000. But
bank statement shows a balance of 110,000.
Net Float = Firm's available balance – Firm's book balance
Net Float = 110,000 – 100,000
Net Float = -10,000
Float Management
Float management involves controlling the collection and
disbursement of cash. 
    The objective in cash collection is to speed up collections and
reduce the lag between the time customer pay their bills and the
time cash becomes available. 
    The objective in cash disbursement is to control payments and
minimize the firm's costs associated with making payments.
Components of Collection Time
1. Mailing Time – is the part of collection and disbursement
process during which checks are trapped in the postal
system.
2. Processing Delay – is the time it takes the receiver of check
to process the payment and deposit it in a bank for
collection.
3. Availability Delay – refers to the time required to clear a
check through the banking system.
Speeding up collections involves reducing one or more of these
components.
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Cash Discount – a discount given to induce prompt payment. Also,

Cash Management sales discount.

Lockboxes – special post office boxes set up to intercept and speed Term of Sales
up accounts receivable collections. Terms: 3/30, n/60
Cash Concentration – the practice of and procedures for moving Credit Days = 60 – 30
cash from multiple banks into the firm’s main accounts.   = 30
Rate per 30 = .03/ (1-.03)
Managing Cash Disbursement days = 3.093%
The firm may develop strategies to increase mail float, processing EAR = ((1+.03093) ^12.17)-1
float, and availability float on the checks it writes. = 44.9%
P = 365/30
Increasing Disbursement Float   = 12.17
Disbursement float can be increased by writing a check on a APR = .03093 x12.17
geographically distant bank. = 37.6%
Credit Instrument
Controlling Disbursement The credit instrument is the basic evidence of indebtedness. Most
Zero-Balance Account – a disbursement account in which the firm trade credit is offered on open account. This means that the only
maintains a zero balance, transferring funds in from a master formal instrument of credit is the invoice, which is sent with the
account only as needed to cover checks presented for payment. shipment of goods and which the customer signs as evidence that
the goods have been received.

Optimal Credit Policy

In principle, the optimal amount of credit is determined by the point
at which the incremental cash flows from increased sales are exactly
equal to the incremental cost of carrying the increased investment
in accounts receivable.

2. Credit Analysis – the process of determining the probability that

Controlled Disbursement Account – a disbursement practice under
which the firm transfers an amount to a disbursing account that is
sufficient to cover demands for payment.
3.
Credits and Receivables
customers will or will not pay. It usually involves two steps:
gathering relevant information and determining
creditworthiness.
Collection Policy – procedures followed by a firm in collecting
accounts receivable. It involves monitoring receivables to spot
trouble and obtaining payment on past-due accounts.

Aging Schedule – a compilation of accounts receivable by the age of

each account.

Components of Credit Policy

A credit policy defines how your company will extend credit to
customers and collect delinquent payments. A good credit policy
protects you from late payments and helps you maintain a healthy
working capital position.
1. Terms of Sales – conditions under which a firm sells its goods
and services for cash or credit.
Collection Effort
A firm usually goes through the following sequence of procedures
for customers whose payment are overdue:
1. It sends out a delinquency letter informing the customer of
the past-due status of the account.
2. It makes a telephone call to the customer.
3. It employs a collection agency.
4. It takes legal action against the customer.
Inventories

Inventory Types
Credit Period – the length of time for which credit is granted.
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For manufacturers, inventory normally is classified into one of

three categories. Carrying Cost = Cost of Restocking 
 Raw Materials

√
 Work-In-Process 2( Annual Demand x Cost per Order )
 Finished Goods EOQ=
Annual Holding Cost per Unit
Inventory Costs
 Carrying Cost – represents all of the direct and
opportunity cost of keeping inventory on hand. The
EOQ=
√
2(46,800 x 50)
.75
EOQ=2 , 498units
include:
1. Storage and Tracing Costs Extensions to the EOQ Model
2. Insurance and Taxes Safety Stock - is a term used by logisticians to describe a level
3. Losses due to obsolescence, deterioration, of extra stock that is maintained to mitigate risk of stockouts
and theft caused by uncertainties in supply and demand. It is the
4. The opportunity cost of capital for the minimum level of inventory that a firm keeps on hand.
invested amount.
 Cost of Restocking Reorder Points - are the times at which the firm will actually
1. Any cost associated with ordering. place its inventory orders.

Inventory Management Techniques Given: AS = 100 qty/day | Lead Time = 10 days | Safety = 5
days
 ABC Approach – is a simple approach to inventory
management where the basic idea is to divide Safety Stock (SS) = Average Sales x nb Safety Days
inventory into three (or more) groups. The ABC Safety Stock (SS) = 100 qty/day x 5 days
approach to inventory should not be confused with Safety Stock (SS) = 500 qty
Activity Based Costing, a common topic in
managerial accounting. Reorder Point = Safety Stock + Average Sales x Lead Time
 Just In Time Model (JIT) – a system for managing Reorder Point = 500 + 100 x 10
demand-dependent inventories that minimizes Reorder Point = 1,500 qty
inventory holdings.
 Economic Order Quantity Model (EOQ) – the
restocking quantity that minimizes the total
inventory costs.

A orders 3,600 units each time and the carrying cost

were .75 per unit per year.

Carrying Cost = Average Inventory x Carrying Costs per

Unit
Carrying Cost = (3,600/2) x .75
Carrying Cost = 1,350

The Annual sales of A is 46,800 and the order size is

3,600. The company spends 50 per order.

Cost of Restocking = Fixed Cost per Order x No. of Orders

Cost of Restocking = (46,800/3600) x 50
Cost of Restocking = 650
Total Cost = Carrying Cost + Cost of Restocking
Capital Budgeting
Total Cost = 1,350 + 650
Total Cost = 2,000 Introduction
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Capital Budgeting
Involves identifying the cash inflows and cash out flows rather than
accounting revenues and expenses flowing from the investment. For
example, non - expense items like debt principal payments are
included in capital budgeting because they are cash flow
transactions.
Theories and Concepts
 Short-Term Cash Budgets
Aim to solve or control cash requirements on a weekly or
monthly basis. These budgets help forecast the payments
that need immediate fund allocation and identify sources
that can help offset this requirement.
(NPV) equals zero (when timeadjusted future cash flows
equal the initial investment). IRR is an annual rate of
return metric also used to evaluate actual investment
performance.
 Depreciation Tax Shield
Is a tax reduction technique under which depreciation
expense is subtracted from taxable income. The amount
by which depreciation shields the taxpayer from income
taxes is the applicable tax rate, multiplied by the amount
of depreciation.

 Long-Term Cash Budgets

Focus on quarterly and annual tax payments, capital
expenditure projects, and long-term investments. Long-
term cash budgets usually require more strategic planning
and detailed analysis as they require cash to be tied up for
a longer period.

 Relevant Cash Flows

Often used for relevant cash flows states that they must
be cash flows that occur in the future and are incremental.
While on the face of it obvious, only costs or revenues that
give rise to a cash flow should be included.

 Initial Cash Outlay

Refers to the initial investments needed to begin a given
project. For instance, if opening a new factory, a company
would need to purchase new land and machinery to get
the project going.

 Payback Period
Is defined as the number of years required to recover the
original cash investment. In other words, it is the period of
time at the end of which a machine, facility, or other
investment has produced sufficient net revenue to recover
its investment costs.

 Discounted Payback Period

Is a capital budgeting procedure used to determine the
profitability of a project. A discounted payback period
gives the number of years it takes to break even from
undertaking the initial expenditure, by discounting future
cash flows and recognizing the time value of money.

 Net Present Value

Is the difference between the present value of cash inflows
and the present value of cash outflows over a period.

 Internal Rate of Return

Internal rate of return is a capital budgeting calculation for
deciding which projects or investments under
consideration are investment-worthy and ranking them.
IRR is the discount rate for which the net present value