WORKING CAPITAL AND CASH MANAGEMENT

Working Capital
Working capital is the difference between the firm's current assets and current
liabilities. It is used as a measure to check the liquidity of the firm. If the firm's
current assets are greater than the current liabilities, it is capable of paying its current
obligations. Hence, if current assets are less than the current liabilities, then the firm
cannot pay its current obligations and has to resort to borrowings. Current assets
comprise cash, accounts receivable, marketable securities, inventory and prepaid
assets. The current liabilities are the short-term obligations that are expected to
mature within one year. Managing the movement of working capital ensures the
continuity of company operations.
Having a well-planned working capital, the company can take advantage of business
opportunities to achieve its goal promptly and meet its financial obligations.
Optimizing the use of working capital prevents excessive investments. Having an
excessive working capital has a negative impact on the profitability and liquidity of
the company due to various factors associated with it.
The Working Capital:
Current assets
Cash and cash equivalents Php xxx
Accounts receivable XXX
Marketable securities of Short-term investment XXX
Inventory XXX
Prepaid assets XXX
Total Current Assets Php xxx

Current Liabilities
Accounts payable XXX
Notes payable-short term XXX
Accrued expense payable XXX
Total Current Liabilities XXX
------------
WORKING CAPITAL Php xxx
WORKING CAPITAL MANAGEMENT
Working Capital Management is concerned with the efficient and effective
utilization of working capital to attain the predetermined objectives of the company
relative to profitability of operations, liquidity of financial resources, and
minimization of risks and company costs. It is also pertinent to the administration
and control of working capital to ensure that it is adequate and effectively utilized.
Working capital management regulates various types of current assets and current
liabilities. It requires decisions on how the current assets will be financed and
utilized. Managing current liabilities, on the other hand, implies maximizing the
company's holding period before the firm finally pays off its obligations.
The top management determines how much investment should be made in current
assets. The investment may change from time to time and requires close monitoring
of the current balances. Current assets are not properly managed if funds are tied up
in one or several assets that do not provide any return when in fact, it could be more
productive and beneficial to the firm if placed somewhere else (Shim & Siegel,
2006).
The goal of management is to maintain a cash level at a minimum without putting
the company at risk, thus maintaining a level of cash that is enough to support the
firm's operations. Maintaining too much cash is hazardous to the company. As the
most liquid among the assets, cash is susceptible to theft. A good finance manager
would not allow such an occurrence because of the risk involved. Any excess cash
should be placed in other investment opportunities like time deposit, mutual funds,
bonds, and capital investments. Paying off the company's obligations would also be
another option to prevent paying for more interest. The management must be fully
aware that having excess cash does not contribute to the firm's profitability because
of the opportunity income attributable to cash.
In managing accounts receivable, the company does not want to be too lax nor too
strict in granting credits. Being too lenient would result in accounts receivable
increases and bad debts. On the other hand, being too stiff on credit would reduce the
accounts receivable at the expense of a decrease in sales. With opposing ideas on
being too lenient or too stiff on granting credit, the company must find a way that
would result in well-managed accounts receivable in terms of collectability and the
viability of extending credit sales.
In managing inventories, investing in excessive stocking levels may result in
obsolescence and losses. Maintaining inventories at a level enough to support the
market demand means a lot of cost savings in terms of warehousing, insurance, and
manpower, among others.
Current liabilities are short-term obligations incurred by the firm to support
operating activities. These may take the following forms: accounts payable, notes
payable, accrued expenses, interest expense, salaries expense and other conceivable
expenses that are expected to be paid in one year. In handling the current liabilities,
the firm has to be prudent in making use of time before it finally pays off its
obligations. Its prime responsibility is to hold on to current obligations that can be
easily handled by its current assets. To a certain extent, current liabilities are
sometimes held even after their maturity date. However, this kind of practice may
put the firm in a situation where its credit rating performance becomes detrimental.

Working Capital Policies

The working capital policies are guidelines on the amount of capital of the
company should maintain. It is concerned with the level and financing of each
component of the current assets. Listed below are the different working capital
policies:
Matching Policy. The policy works in an arrangement where the current assets of
the business are used to perfectly match the current liabilities. Under this policy, all
the fixed assets plus the permanent current assets are financed by long-term
liabilities or equity.
Aggressive Policy. This type of policy has a high risk and often high return to the
company. The company keeps a low amount of current assets to support the
operations.
The purpose of adapting an aggressive policy is to take the opportunity of having a
lower interest charge for short-term liabilities instead of long-term liabilities.
However, this type of strategy is quite risky due to the fact that interest rates
fluctuate in shorter period of time. Also, the firm may also be at risk in terms of loan
renewal and increasing interest rate.
Conservative Policy. Among the three working capital polices, the conservative
policy has the lower risk and lowest return. In this type of policy, the company
matches a portion of the temporary current assets, and the entire permanent current
assets and fixed assets with long-term liabilities or equity issuances. The remaining
portion of the temporary current assets not financed by long-term financing is funded
by short-term liabilities.
How is Working Capital Managed?
Managing working capital is done in numerous ways. Listed below are some of the
possible ways that could help improve the firm's management:
Looking at the Financial Ratios. Financial ratios play a crucial role in managing
working capital. It draws important information that the firm may use in order to
improve its working capital.
For instance, a firm with a high current ratio but a low quick ratio gives high
investment in inventories. High investment in inventories does not necessarily have a
bad impact on the firm's profitability if such investment has a high turnover.
However, if the firm has a high level of inventories but low turnover, it signifies that
the firm is not creating sales. Thus, a high and slow moving inventory will result in
spoilages and high cost of maintenance. With the information provided by the
financial ratios, the firm becomes aware of how to handle its inventories at a level
that would minimize costs.
Another example is if the firm has a high current ratio coupled with a high quick
ratio. This condition gives the firm a high level of either cash, accounts receivable,
marketable securities, or any combination of the three. Having a very high
investment in cash is risky because of its susceptibility to theft. Too many receivable
may lead to non-collection and cash shortage. If high current ratio and quick ratio are
the result of a high investment in short-term marketable securities, it can be
concluded that the firm is knowledgeable in properly handling excess cash.
Putting up proper internal control. Internal control has an important part in
securing the working capital of the firm. With proper internal control, irregularities
could be avoided if not totally eliminated. Proper internal control of cash averts theft,
mishandling, or misappropriation; proper internal control of inventories prevents
unauthorized releasing of goods from the warehouse; and proper internal control of
receivables disallows the non-recording of cash collections. The different units of the
organization should take part in the control process. Each unit should have its own
control measures to curb any irregularities that could effect the working capital of
the firm.
Changing Company Policies. Policies serve as guideline in executing the
transactions and activities of the company. However, if the existing policy does not
contribute to the general welfare of the firm, changing it would be a better option.
For instance, continually declining sales may be the result of not being too
competitive in giving credit terms. If the firm's current practice is giving a credit
term net/30 days, and the industry on the average is giving 2/10, n/30, then why not
offer the same or even a better credit term of, say, 3/10,n/30? This way, the firm
could entice its present customers to acquire more and may even get a good share of
the market for changing its credit policy.
Preparing the budget. Doing the budget for the entire year is a good tool to help the
company manage its working capital. Through this budget, the firm can clearly
identify the time when additional working capital is required or when it has an
excess working capital. The top management will also have a clear picture of what
activities they could undergo in a short period of time to help improve the firm's
performance.
CASH MANAGEMENT
Cash is a current asset used to purchase raw materials, pay for labor, buy capital
assets, and pay for dividends, taxes, and obligations. Although cash is the life
support of the company, it does not earn interest for itself if not managed properly.
Mismanagement of cash deprives the firm of the opportunity to earn more. In this
sense, the objective of cash management is to minimize the use of cash and maintain
optimum cash at the right time. Good ash management knows how much cash is
needed in conducting the firm's normal business operations while having sufficient
cash to meet unexpected needs. Likewise, it ensures that excess funds are placed for
investment (Ross et al., 2008). Cash, being the most liquid of all the asset, must be
carefully planned and controlled.
Cash management holds on to marketable securities to avoid cash shortages. Firms
whose operation is seasonal may opt to buy marketable securities when they have
excess funds and sell the same securities in times of cash shortage. The investment
portfolio should pay attention to return on investment, the risks involved,
disposability or marketability, and maturity dates.
Cash management is also concerned with the acceleration of cash receipts and
suspension of cash disbursements.

REASONS FOR MAINTAINING CASH

Firms hold on to cash for numerous reasons: performing normal operations, safety
reasons, taking advantage of an unforeseen investment activity, and many more
(Levy, 1998).
Listed below are the most common reasons for maintaining cash.
 1. Transaction motive. This refers to the intention to meet the minimum
business operations requirement. Thus, cash balance should be enough to pay
for the routine payments such as obligations to creditors, periodic payroll,
supplies, and overhead and other predictable expenses. With this motive, cash
collections must be immediately deposited. Fluctuations between the
collections and disbursements result in changes in cash requirements.
Shortage in cash collections results in borrowings and any excess funds may
be invested in marketable securities.
2. Speculative motive. This leads to the use of cash balances to take advantage
of bargain purchases on materials or unusual cash discounts. Firms believe
that they will be better off if they grab any opportunity in the market by
immediately paying cash.
3. Precautionary motive. This results in holding cash for unforeseen
fluctuations in cash inflow and outflow. Maintaining credit lines with banks
is usually done by firms to meet their precautionary needs. This way, the
need for maintaining cash is reduced.

CASH EQUIVALENTS
Cash equivalents are short-term, highly liquid investments that are readily
convertible to cash. These are investments which are so near their maturity dates,
making risks inherent to the investment insignificant. Based on the Philippine
Accounting Standard No. 7, investments with the original maturity of three months
or less is qualified as a cash equivalents. Thus, the purchase date must be three
months or less before the maturity date.
Firms usually take advantage of placing their excess funds in cash equivalents rather
than maintaining a credit line. A credit line is a loan granted by banks for a certain
amount for a particular period. Borrowings normally require a compensating balance
in the firm's account in exchange for the services provided by the bank. Although
compensating balance also earns interest, it is considered inferior to cash
equivalents.
Examples:
1. A 90-day treasury bill
2. A 180-day treasury bill purchased within 90 days before its maturity
3. 1 90-day time deposit
4. A 90-day commercial paper
5. Long-term commercial paper purchased within 90 days before its maturity.
6. Other money market instruments whose maturity is within 3 months.
Advantages of Holding Cash or Cash Equivalents
Taking advantage of the trade discounts. Suppliers give discounts to encourage
early payments. Thus, payments within the discount period results in less outflow of
cash. However, cost and benefit analysis must be done before availing of such
discounts.
Maintenance of good credit rating. Having a good current and quick asset ratio on
a par with the industry, the firm will be able to maintain good credit standing with
suppliers offering favorable credit terms and with banks giving low interest rate.
Favorable business opportunities. Firms may take advantage of special offers from
suppliers and a possible takeover of another firm.
Meeting emergencies. Firms may immediately recover losses brought about by fire,
typhoons, strikes, and other unexpected events.
Capacity to compete. Having enough cash enables the frim to face its competitors
by expanding or developing new products or advertisements.

FACTORS AFFECTING CASH REQUIREMENTS

Listed below are some of the factors that affect cash requirements.
1. Firm's policy on cash management. This refers to the amount of cash a
firm needs to cover for a certain number of days of the business operations. It
is dependent on how fast cash is generated by the firm.
2. Availability of loans. A firm with good credit standing may hold a cash
balance at low levels without putting the firm at risk. Funds are always
available when the need arises.
3. Forecasted cash inflow and outflow. Differences between the inflows and
outflows are determined by analyzing the collections and disbursements
records of the firm. The fluctuations between the two provide a rough
estimate on the amount of cash needed to prevent a shortage of cash.
Forecasting cash movements helps the firm ascertain the proper timing of
financing and debt repayment.
4. Unpredictable events. Firms should not only account for predictable
collections and disbursements. They should also prepare for any
unpredictable event by holding marketable securities or securing credit lines.
 Estimating unpredictable events may save a lot of time and money for the
firm. Not meeting any unpredictable increase in demand of the firm's
products also reduces opportunity income.
Possible Placements for Excess Cash
Firms with good cash management would know the amount of funds available for
investment as well the length of time it can be invested. Having idle funds for a
certain period of time is a good source of an incremental income (Harrington, 2004).
Some of the possible places of investments are as follows:
1. Savings and/or current accounts. These are bank placements with no
holding period. However, interests earned in these kinds of placements are
lower than those earned in time deposits. In the past, the current account does
not bear interest, but because of the growing need of firms, other financial
information now offers current accounts that bear interest. However, the
interest offered by a current account is lower than the interest offered by a
savings account.
2. Time deposits. These are placements with holding period. Time deposits are
normally taxed at 20% of the interest income. These are placements offered
by banks that earn a higher interest than the savings account.
3. Stocks. These are shares of stocks traded in the formal stock exchange and
are bought from stockbrokers. Stock entail costs which include broker's
commission, government taxes and documentary stamp tax.
4. Treasury bills. These are short-term obligations issued by the government.
Treasury bills are usually offered with a maturity of 90 days or 3 months.
However, there are treasury bills that mature in more than 3 months but less
than a year. Treasury bills are unique because these are traded on a discount
basis, that is, it earns interest until the maturity date. The maturity value less
the discounted value is the profit earned for investing in treasury bills.
5. Commercial papers. These are unsecured promissory notes issued by firms
with high credit standings. The interest earned from commercial papers is
normally higher than that from the savings account. No collateral is offered
by firms that issued the commercial papers because of the firm's good track
record of cash inflows.

Controlling Cash Flows

Controlling the cash flow is the main objective of cash management. Through the
year, firms and finance partners alike have been finding ways and means to
maximize the use of cash. Maximizing the use of cash means minimizing cash
outflows and maximizing cash inflows.

The following tools may be used for controlling cash flows:

1. Synchronizing cash flow
2. Cash floats on
a. Payments
b. Collections
3. Extending cash payments
4. Availing of cash discounts
5. Optimum transaction size

Synchronizing Cash Flows

This is a process in which the cash inflows coincide with the outflows. A
synchronized cash flow is highly dependent on an accurate forecast of inflows and
outflows. A more accurate forecast helps the firm minimize its cash balance since it
can immediately determine the time when cash will actually be needed. As a result,
there will be less borrowings, lower interest expense, and maximized profits.

Floats on Disbursements
These are the differences between the company's book balance and bank account
balance in any period of time. Floats exist when the firm issues its own check and
sends it to the payee company. The payee, in return, has to deposit the check in their
bank account. The number of days from the issuance of the check to its clearance
is known as float days. The issuer of the check prefers that the recipient deposits the
check in its own bank account at a much later date. This is because the time interval
or float days give the check issuer an additional time to use the fund. Contrary to
this, the recipient of the check would prefer to have the check en-cashed for
immediate used. However, for various reasons, the check may not be deposited in the
bank. Factors like misplacement of the check, getting lost in transit, or technical
errors or problems in the check presented are only some of the reasons for the delay
of clearing. Geographical location is also another factor in which the clearing of
checks may be delayed. Checks are cleared depending on the type check issued. An
on-us check takes a day for clearing, local checks are three days' clearing, the
regional checks take five to seven days, and out-of-town checks take about seven to
ten days.

A float can be classified into three categories:

1. Mail float. It is from the time the check is issued up to the time the check is
received by the payee. Undeposited Collection part of cash on hand if dated
check; cannot be used.
2. Processing float. It is from the time the check is received by the payee until
the time it is deposited in the payee's bank account. Deposit in transit in bank
recon; part of cash; cannot be used.
3. Clearing float. It is from the date the check is deposited up to the date the
check is cleared and made available for use. Cash that can be used.
For the issuer of the check, a float gives a considerable advantage to working capital.
Extending the clearing of the issued checks provides the firm with an additional
costless source of short-term financing.
On the other hand, the recipient has to think of ways to reduce the float days. Firms
that are highly dependent on collections to support their operations have to expire the
clearing of checks.

Accelerating Collection of Funds by Reducing Collection Float

1. Collecting center or agent. Float can be reduced by strategically locating
collection center near the customer. The collection center can be a firm
providing a collection service, or a bank where payments are made directly to
the firm's account. Having collecting center near the customer may even lead
to a zero float, making the check collection as good as cash.

A firm may also consider the possibility of having its own collecting agents
or collecting centers, if it is economically possible to reduce the collection
period in a certain area. The finance manager should be able to determine the
additional cost associated with this separate set-up and the benefits attached
to it to arrive at the possible solutions.

Example:
Campau Corporation has an agreement with Mari Commercial Banking Corporation
(MCBC) to collect Php3,000,000 a day in exchange for compensating balance of
Php1,000,000. The firm, with a significant increase in its customer in the area, is
thinking of canceling the agreement and dividing the service provided by MCBC
with MNO Bank. With this plan. MCBC will handle the collection of Php2,000,000
with compensating balance of Php800,000. On the other hand, MNO bank will
handle the other Php1,000,000 collection in exchange for a compensating balance of
Php700,000. With the planned arrangement with the two banks to perform the
collection, the firm is expecting to reduce the collection period by one day. The
firm's rate of return is 9%. Should Campau Corporation pursue the division of
service between MCBC and MNO bank?

Analysis of the problem is as follows:

Amount of cash collection per day Php 3,000,000
Number of days freed on the collection x1
-----------------
Amount of cash freed Php 3,000,000
Less: Increase in compensating balance 500,000
-----------------
Increase in cash flow Php 2,500,000
Rate of return x 0.09
------------------
Incremental income Php 225,000

Based on the analysis above, Campau Corporation should pursue the plan of dividing
the service between MCBC and MNO bank. Despite the increase in compensating
balance from Php1,000,000 to Php1,500,000, the firm will be able to increase its
cash outlay by Php2,500,000 resulting to an incremental income of Php225,000 per
year.
2. Lockbox system. It is a system where the company has a "P.O. box number"
address. This P.O. box (Post Office box) is rented in a postal office where all
collections made by the customer will be directed to. Lockboxes are normally
managed by banks. A bank employee goes to the post office to empty the
postal box and immediately deposits the check payment made by the
customers. Several factors, like average size of the receipts from customers,
quantity of receipts collected per day, and average number of mail received,
have to be considered before selecting the location of the lockbox. A lockbox
is not offered free by whoever is willing to render the service. Firms who like
 to avail of such a service have to consider the costs involved. A cost-benefit
analysis has to be made before deciding whether or not to make use of the
lockbox system. The variables in the analysis are: cost of the service, number
of days in which the float is reduced, the amount of check to be converted
immediately into cash, and expected rate of return on the cash freed. To be
acceptable, the benefit should be greater than the cost of the lock box system.
Below are some examples related to a lockbox system.
Example A:
Paucam Corporation has average cash receipts of Php150,000 per day. Normally, it
takes 7 days from the time the check is received for it to be made available as cash.
How much cash is tied up?
Computation shall be as follows:
Average cash receipts per day Php 150,000
Number of days tied up x 7 days
-----------------
Amount of cash tied up Php 1,050,000

Example B:
Paucam Corporation has an average of seven days to receive and deposit the checks
from customers. The owner believes that it takes too long for the firm to use the
funds to support its operations. In answer to this problem, a bank offers its service
through the use of a lockbox system. The banker explains that with the system in
place, the expected float time will be reduced to 4 days. The bank charges Php10,000
per month to its overhead on the service. Should Paucam Corporation avail of the
service offered by the bank? How much is the advantage or disadvantage of the
lockbox system, considering the firm's average daily collection of Php450,000 and
the annual rate of return of 12% in the market?
The Cost-Benefit Analysis is as follows:
Average cash receipts per day Php 450,000
Number of days cash is freed (7days-4days) x3
-----------------
Amount of cash freed-up 1,350,000
Rate of return X 12%
-----------------
Expected return (benefit) 162,000
Less: Cost of the lockbox system (Php10,000 x 12) 120,000
 ------------------
Net advantage of availing the lockbox system Php 42,000

Since the net advantage is worth Php42,000, then Paucam Corporation should avail
of the service offered by the bank.

3. Concentration banking. This is another way of accelerating the collection

of funds. A firm doing business over a wide geographical area normally
maintains several accounts in different banks. The accounts are used for
several reasons, including payroll of employees in the different parts of the
country or region, payments to the suppliers, receipts of collections from
customers, and other transactions that may be accounted as normal operations
of the firm. The firm usually improves its total cash balances by collecting its
receivables from different regions and electronically concentrating the
transfer of funds to one bank or branch. The bank offers this type of service
by signing a memorandum of agreement where all terms and conditions are
stipulated. Normally, banks require a compensating balance or an average
daily balance before such service is offered.
One good example of concentration banking is the remittances made to Social
Security System (SSS), whose main account is being maintained in the RCBC head
office in Makati. This government agency has numerous accounts in the different
branches of RCBC all over the country. payment is deposited by individuals to the
place where they are geographically located, say, in the RCBC Baguio branch. This
receiving RCBC branch in Baguio in return will transfer the fund collection by
debiting its account and crediting the main account of SSS in RCBC head office.
Concentration banking has many forms. Some of them are: direct sends where
checks are sent directly to the drawee bank; direct deposit to the company's bank
account, provided that the bank is already on-line; and an auto-debit arrangement
wherein the payee's account is credited while that of the payor is debited.
Once collections have been accelerated, the amount of cash freed is immediately
invested in marketable securities or used to pay off short-term obligations. With this
investment, the firm is able to generate additional income in the form of interest on
the investment. Likewise, if payment on obligation has been made, the firm will be
able to minimize its cash outflow due to savings on the interest expense. The revenue
obtained is determined by getting the average accounts receivable balance times the
monthly interest rate.
Example:
A firm's monthly average cash balances are computed as follows:
Monthly Average cash balance
1 Php 25,000
2 30,000
3 40,000
4 60,000
--------------------------------------------
Total Php 155,000

The monthly average cash balance is:

Php 155,000/4 = Php38,750
If the annual interest rate is at 15%, the monthly return earned on the average cash
balance is:
Php38,750 x 0.15 x x 30/360 = Php484.38
It must be noted that in considering the system in accelerating funds, the benefit on
the freed cash should be more than the cost of the system. In addition, the finance
manager must be knowledgeable about the bank's policy on availability of the funds,
where the company receipts are coming from, and the ways and means for checks to
be received immediately.

Extending Cash Disbursement

Cash management has two sides: the cash inflow and the cash outflow. The previous
discussions were about cash inflow or the acceleration of funds to support company
operations and to gain additional income on the cash freed-up. The other half of cash
management, the cash outflow, is concerned with how cash disbursements can be
extended from the time the billing statement is received.
Stretching payables is an obvious way of extending cash disbursements. However,
this practice has drawbacks. At a certain point, after a series of contraction of the
supply of money, the suppliers will no longer tolerate the firm's practice, which will
result in the cut-off of the credit line. Although may firms in the past and even at
present have been doing this, the risk of losing their creditors is always a burden on
their shoulders. Nevertheless, it is also not advisable to pay the obligation before the
stipulated date. Paying the obligation on the date as agreed and using the money until
the maturity date is a good practice. There are suppliers who grant cash discounts to
buyers who pay their obligations within the discount period. If the buyer likes to
avail of such a discount, a cost-benefit analysis has to be conducted before making a
decision.

Ways to Conduct Cash Disbursements

1. Playing the float. This is the process of taking advantage of the clearing
system in order to make use of the funds in the firm's bank account. Checks
in transit from the company to its creditors or checks deposited in another
bank are not yet deducted from the company's bank account. The account is
only deducted when the check is physically transmitted through the bank
clearing system. And even if the check is physically transmitted, it does not
necessarily debit the account immediately. The clearing system takes about
three days of clearing for local checks, five to seven days for regional checks,
and seven to ten days for out-of-town checks. The company can still make
use of the money for a number of days, depending on what checks are
deposited while in the clearing system. Firms who are knowledgeable of the
clearing system takes advantage of this feature by means of opening an
account in a bank in a remote area, which is not yet covered by the clearing
system or is not yet on-line. Through this process, the firm saves several days
before their account is debited fro payment on checks deposited.

Playing the float reflects that the outstanding checks of the firm not presented
to the bank are more than the amount covered by the bank balance. If a bank
reconciliation is to be made, the book balance will reflect a negative balance
because the checks issued will be more than the amount the firm has in the
bank. On the other hand, it will reflect a positive balance at first simply
because of the floats on the checks issued. Firms that observe this practice
have to deposit the needed cash before the check is cleared. Otherwise, they
will incur penalty charge and service charge and service charge for issuing an
overdraft check. Other firms, instead of depositing cash, deposit checks to
cover the check issued before it clears in the banking system. This kind of
cover-up is called kiting, which is not an advisable practice because of its
technicality.
2. Payment by draft. A draft is an unconditional order made in writing
addressed by one person to another, signed by the person giving it, requiring
the receiver to pay on demand or at a fixed or determinable future time a
certain sum of money to order or to the bearer. A draft is issued by the debtor
(issuer) to the creditor. The creditor then presents the draft to the issuer's
bank for collection. The issuer's bank will then present the draft to the issuer
for acceptance. Once accepted the issuer of the draft will then deposit the
funds to cover the amount of the draft. The advantage of the draft is that it
delays the disbursement of funds to the creditor. Although payment already
took place between the debtor and the creditor, the actual transfer of funds of
the issuer from its own account is not immediate. The delay happens from the
time the draft is issued to the creditor, to the time it is presented to the bank,
and up to the time the bank has to present it again to the issuer for
acceptance. This procedure, in addition to the floats created by issuing a
check, further prolongs the disbursements of funds.

3. Auto-debit transfer. An auto-debit transfer is one of the services by the

bank. To avail of this kind of service, the firm has to maintain a certain
amount in their account, normally called average daily balance. This bank
service provides the firm two or more accounts to facilitate payments and
collections. One account is a savings account while the other is a current
account (demand or checking account). The current account is maintained
with a zero balance. All payments to be made by the firm are through checks
and all deposits or collections will be made on the savings account. When a
check issued by the firm is presented to the bank, the amount to be charged to
the current account will be funded automatically by the savings account.
Thus, an appropriate transfer from savings account to current account is
made electronically to cover the amount of the check presented.

4. Debit transfer. The features of this service are practically the same as those
of auto-debit transfer. The only difference is that the debit transfer is done
manually, usually at the end of the banking day or early on the next banking
day. The amount of funds to be transferred to the current account is
determined by the total of all charges made to the firm. It transfers just
enough funds to cover the checks presented for payments. Again, although
checks have already been issued by the firm, the amount for disbursements is
only transferred once the amount is determined. A debit memo is entered
against the savings account of the firm and a credit memo is then made for
the current account.
 5. Stretching of payables. This is the process of extending payments to
suppliers or creditors. Although this is not advisable as mentioned, this
practice is normally done in the industry. It should be noted, however, that in
the stretching of payables, it is important that payments should only be
delayed for a time that is tolerable to the creditor.

6. Centralization of disbursements. Other firms control their cash

disbursement by centralizing it. This way, firms are able to monitor their
payments and satisfy their obligations to the optimum time. Firms can select
creditors who must be paid first and extend payments to those who can
tolerate delays.

7. Use of statistics to predict the amount of checks issued. By looking at the

historical disbursements of the firm, one can establish how much funds must
be deposited to cover the checks issued. Normally, this is done for payroll
and dividend payments. The firm opens an account exclusively for these
disbursements which do not necessarily cover the entire amount of payroll or
dividend payments. In order to minimize the cash balance for this account,
the firm has to establish, on the average, the amount of the checks to be
presented by its employees or the beneficiary of the dividends. The firm can
approximate the funds it needs to cover the check issuances based on
experience.
Example:
Salary payment of ABC Company is made every 15th and 30th of the month through
issuances of checks. It pays Php5,250,000 per payroll. However, based on the
historical clearing of checks issued on salary; 50% will be presented on the day
itself, 35% five days from the salary date; and the remaining balance on the 10th day
after the salary date. If the interest rate on market is 12% per annum, how much is
the incremental income of ABC Company if the entire amount is not deposited?
An analysis of the problem is as follows:
Incremental income from salary date to five days
From salary date (Php5,250,000 x 50% x 12% x 5/360) Php 4,375.00

Incremental income from five days to tenth day

From salary date (Php5,250,000 x 15% x 12% x 5/360) 1,312.50
 -----------------
Total incremental income Php 5,687.50

By not covering the entire amount of the payroll, the firm will generate an
incremental income of Php5,687.50. Thus, the firm has to deposit only the amount of
Php2,625,000 on the day of salary payment and the remaining balance of
Php2,625,000 can be placed in the market at 12% per annum earning an interest
amounting to Php4,375. The next deposit will take place on the fifth day from the
salary date amounting to Php1,837,500 and the remaining balance of Php787,500
shall be placed again at 12% that would earn an interest amounting to Php1,312.50.

Cash of Foregoing a Cash Discount

Cash discount is categorized under short-term financing. However, for the purpose
of discussion, it will be included under cash management. Cash discount is offered
by suppliers of goods to the purchasers to encourage them to make an early
payments. Not paying within the discount period is an opportunity cost to the firm. A
firm without fully knowing cost of discount will typically take advantage of a
discount offered by the creditor because of the attached opportunity cost. However,
going beyond the normal understanding of the term, cash discount, will make a
difference.
The credit term is payment term where credit is granted to a customer. Its benefits
include the credit period, the cash discount offered, and the discount period. For
instance, if the term of sale is 2/10, n/30, the customer will get a 2% cash discount if
the purchase is paid within ten days, Otherwise, the total amount of obligation is due
on the 30th day.
Formula of Cash Discount
Cost of discount = discount%/100%/100%-discount% x 360/30-10
The trade credit is a liability arising from credit sales. The seller records it as an
account receivable and the buyer records it as an account payable. If the term of the
sale is 2/10, n/30, the first 10 days represents the free trade credit and the remaining
20 days represents the costly trade credit. If the buyer does not pay during the
discount period, the buyer is obliged to pay in the 30th day. The cost of discount is
computed as:
Cost of discount = 2.0%/100%-2% x 360/30-10
= 0.020408 x 18
 = 0.367344 or 36.73%
It can be ascertained that the cost of discount if not availed of will cost the firm
36.73%. The cost of discount forgone declines as the net period becomes longer in
relation to the discount period. Thus, if the term above has been 2/10, n/45, the cost
of discount forgone will have been:
Cost of discount = 2.0%/100%-2% x 360/45-10
= 0.020408 x 10.2857
= 0.2099 or 21%

When to Avail of Discount?

Before availing of the cash discount, the firm should conduct a cost-benefit analysis
first. Thus, if the borrowing rate in the market is greater than the cost of the discount,
then it will be better not to avail of the cash discount. On the other hand, if the
borrowing rate is less than the cost of discount, it will be better for the firm to take
advantage of the cash discount.

Example:
ABC Company is considering the discount on the credit term offered by the supplier.
The terms are 4/10, n/60. At the time the term is offered, the borrowing rate in the
market is 12% per annum. Should ABC Company avail of the discount offered?
The analysis will be as follows:
Cost of discount = 4.0%/100%-4% x 360/60-10
= 4%/96% x 360/50
= 0.041667 x 7.20
= 0.3000 or 30%
Since the cost of borrowing is 12% which is lower than the cost of discount forgone.
ABC Company should avail of the discount. Thus, the firm may borrow from the
bank at the rate of 12% and pay the supplier at a discounted rate. The net advantage
of the firm from the discount is 18% (30% -12%).

Determination of Optimal Transaction Size

William J. Baumol is the first economist to observe that the economic order quantity
(EOQ) applied to inventory management may also be integrated in the management
of cash balances where cash will be considered as a particular type of inventory.