Working Capital Management

I. OVERVIEW
The working capital policy of a company refers to the level of current assets invested
to attain a desired sales level. The choice of policy depends on the factors such as
risk, profitability, and liquidity. There is a trade-off between profitability and
liquidity. The objective of the finance manager is to strike a balance between
profitability and liquidity while controlling the level of risk exposure.
II. WORKING CAPITAL POLICIES

The choice of working capital policy is a balance between profitability, liquidity and
risk. The following are the most common types of working capital policies.

1. Aggressive or Restricted

Companies that adopt aggressive working capital tend to have a very low level
of current assets thereby lesser need for short-term financing, resulting to low
working capital. This situation will result to savings on interest expense and
increasing profitability and higher ROI. Companies using this policy have high
profitability but are exposed to liquidity risk.

The estimation of the needed current assets to achieve target profitability is

done very aggressively that no adjustments or concessions are made for the
unforeseen circumstances. This situation will increase the risk because of the
aggressive policy.

2. Conservative or Relaxed
Conservative of the exact opposite of aggressive policy. Companies that adopt
conservative policy tend to have higher levels of current assets thereby greater
need for short-term financing. This will increase financing cost thus lowering
profitability or ROI. Working capital tends to be high in this situation. Companies
using this policy trade-off profitability to attain liquidity. The risk exposure is
very low to virtually none/
The estimation of the required current assets to sustain operations is based on
careful study of factors surrounding the company. Adjustments are made to
cushion the effect of unforeseen circumstances.
3. Moderate or Maturity Matching or Hedging
Moderate policy is a balance between the aggressive and conservative. It
combines the features of both policies. Some level of profitability is given-up to
attain sustainability. Overall profitability is between the two policies. The risk is
lower than aggressive but higher than conservative.

MANAGEMENT OF CASH

Cash is money or currency to which all liquid assets can be reduced. It is available for the
disposal of the company. The objective of cash management involves the control of cash inflow over
outflows; moreover, maintain liquidity without sacrificing profitability from idle funds.

Reasons for Holding Cash

1. Transaction Motive- a company maintains sufficient cash to pay its operating expenses. It serves
as an assurance to maintain smooth operations of the company.
2. Safety motive- cash balances are maintained to serve as buffer against demands of cash.
3. Speculative motive- cash balances are maintained to take advantage of unseen opportunities
that may need cash outlay.
4. Bank relationship requirements- most banks require minimum daily cash balance from their
clients. It may serve as compensating balances or mere maintaining balances.
FLOAT

Float is the time between cash payment and the point that the cash is in the hands of the payee
already available for his disposal. It arises from time delays in mailing, processing and clearing checks
through the banking system. At the point of view of the payor it is the disbursement float, on the other
hand, the payee calls it the collection float.

Sources of float

1. Mail float
– the delay between the time the payment was mailed to the payee and the time when the
payee receives it. Mail float depends on the distance between the payor and the payee. The
greater the distance the longer the mail float.
2. Processing float
- The delay between the receipt of a check by the payee and the deposit of it in the firm’s
account. Usually processing float takes two days because normally collections for the day
are deposited the next day.
3. Clearing float
- Arises from the time required for a check to clear the banking system. Clearing float
depends on the nature of the check as well as the place where the check was issued.

CASH MANAGEMENT STRATEGIES

A. Speeding collections/ minimize collection float

a. One of the objectives of cash management is maintaining liquidity. Liquidity is the
company’s ability to convert its assets into cash. The following are strategies or
techniques that speeds up the collection which also minimizes collection float.

Collection Banking- payments are made to regional collection center, and the deposited in local
banks for quick clearing. Shortens mail and clearing float.

1. Lockbox system- the payor will send its payment to a designated post office
box near its area. The various post office boxes are under the payees’ name.
the payee’s local bank will empty the box several times during the day and
deposits the collections to the payee’s account. Shortens processing, mail, and
clearing float.
2. Direct sends- the payee presents the checks arising from the collections
directly to the bank where they were drawn. Since the checks are immediately
converted into cash it reduces clearing float.
3. Pre-authorized check or post-dated checks- the payor issues post-dated
checks to the payee for an agreed amount. The payee simply deposits the
check for collection.
4. Depositary transfer check- a check drawn from the company’s regional bank
to be deposited to its primary bank.
5. Wire transfers- these are telegraphic communication that removes finds from
the payer’s bank and deposits them into the payee’s bank. Eliminates mail and
clearing float.
 6. Automated clearing house- preauthorized electronic withdrawals from the
payer’s account that is transferred to the payee’s account via a settlement
among banks by the automated clearinghouse.
B. Controlling disbursements/ maximize disbursement float
Another aspect of liquidity is the availability of liquid assets such as cash. The following
strategies or techniques will slow down disbursement assuring availability of cash.
1. Controlled disbursing- the use of mailing points and bank accounts to
lengthen mail float and clearing float.
2. Playing the float- using the payment in an interest generating activity during
float, or delay associated with the payment process.
3. Staggered funding- usually applicable to payroll disbursements. The company
does not immediately deposit to its payroll account the entire payroll, instead
deposits on a staggered basis based on company’s past experiences and keeps
on depositing until the full amount is paid.
4. Payable-through draft- In lieu of checks, a draft by the payor issued to a
specific payee but not payable on demand, the draft requires an approval of
the payor for the nak to pay the draft.
5. Overdraft system- the bank of the payor will pay all checks presented against
the firms account regardless of the firms account balances.
6. Zero-balance account- the payor maintains a checking account that has no
amount deposited to it, the payor then transfers funds to the account only to
cover checks drawn against it.