L5 FINANCIAL MANAGEMENT

WORKING CAPITAL MANAGEMENT II

Question 1.
The three main reasons why companies choose to hold cash are as follows:

(1) Transactions motives: companies need cash in order to remain liquid (solvent) on
a day to day basis. Cash inflows are never perfectly aligned to cash outflows and
hence a balance or 'float' is needed to smooth out the lag between cash coming in
and cash going out. Companies can predict the size of cash balance needed by
forecasting their cashflow and identifying early any period where there are surpluses
or deficits. A cash balance can then be built up to fund a deficit and run down in
times of surplus.

(2) Precautionary motive: cashflow forecasting can be incredibly difficult in some

businesses and the consequences of a cashflow shortfall can be quite dramatic. As
a result, some companies hold precautionary cash balances to ensure that higher
than forecast cash outflows or lower than forecast cash inflows do not cause short
term solvency issues.

(3) Speculative motives: companies may build up cash reserves so they can act
quickly if an attractive investment opportunity arises, for example the takeover of
another company. Investment opportunities may not exist at the current time, but
funds are held speculatively in case an opportunity emerges. By being able to move
quickly and not having to wait to raise finance companies can often negotiate the
best deals and conclude a deal before competitors become aware.

Question 2.
The factors to be considered when investing surplus funds are as follows:

 there must be no risk of capital loss

 the size of the cash surplus
 the maturity of the short-term asset
 the yield required
 the need/likelihood for the need for early encashment

Three appropriate short-term instruments:

 Treasury bills and short-dated gilts: T-Bills come in 3, 6 and 12-month maturities.
Gilts are longer but ones with less than a year to maturity can be used. This
investment is low risk but also low return
 Sterling certificates of deposit: minimum investment of £100,000. Bearer-form
securities with maturities ranging from 28 days through to 5 years. They can be
traded on the money markets and are a liquid security, hence carry lower rates of
interest than term deposits. They are higher risk than treasury bills though so
should have higher yields.
 Term deposits: money deposited short-term with banks. Flexible time and size
wise but not always flexible if access to the funds is needed at short notice.

1
LECTURE 7
 L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II

Question 3.

(1) Assuming that offering credit is necessary, or the benefits have been proven
to clearly outweigh the costs the credit worthiness of new customers should
be assessed and reviewed on a regular basis. Relevant information should
be obtained from a variety of sources, including:

 Bank and trade references

 Published information, such as accounts and the press Class discussion
 Credit reference agencies, such as Dunn and Bradstreet
 Company’s own experience

In addition, the credit analysis system should adopt a cost-effective approach,

so that the extent of the credit assessment should reflect the size of the order
size, the likelihood of subsequent business, and the amount of credit
requested.

Finally, when credit has been granted to a new customer there should be an
initial period of intensive monitoring to ensure that the agreed credit terms are
adhered to. Any non-compliance in the initial credit period may indicate that
long term the customer may turn out to be unreliable and therefore should be
treated with caution.

(2) The key to good credit management is the consistent deployment of clear
credit policies upheld by unambiguous accountability within the company.

The credit terms offered to a customer should be clear to them and they
should be reviewed regularly. Credit limits should be revised downwards if a
customer becomes a default risk but also if the credit limit is not being used
and is above their needs.

The customer should be clear from the outset what will happen if the terms of
the agreement are breached. For example, what compensatory interest will be
charged? and when will debt collection procedures be invoked? A customer's
current credit position should always be reviewed before accepting further
orders.

Once an efficient credit management and receivables process has been

embedded there are additional tools available to companies to improve credit
management.

Credit insurance is widely available, and it enables a business to indemnify

itself against bad debt. Insurance can be against all debts (usually with a
single account maximum) or specific accounts. The proportional cost of the
insurance premium versus the likely bad debt cost needs to be compared
when considering this type of insurance policy.

Offering early payment incentives (e.g. discounts) can be considered as a

method to speed up cash inflow and potentially reduce bad debts. Like

2
LECTURE 7
 L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II

insurance, the cost of the discount must be considered against the cashflow
benefits and reduced bad debt.

Early payments should not be confused with invoice discounting. Invoice

discounting is the concept of selling the debt to a third party for an amount
less than its face value. Whilst this yields a reduced return compared to
collecting the full debt directly, the earlier cash inflow and reduced bad debts
offer potential savings.

Finally, a company can outsource its credit management and let a factoring
company take care of the whole process. A factoring company should ensure
good credit management as it is their core competence. A factor will provide
cashflow benefits by advancing money against invoiced debt and may also be
able to provide a reduced (or zero) bad debt liability if the arrangement is
agreed 'without recourse'

Question 4.
£ £
Current level of trade receivables = 197,260
(1,600,000 x 45/365)

Proposed level of trade receivables:

Not taking the discount = 118,356

(60% x 1,600,000 x 45/365)

Taking the discount = 17,534

(40% x 1,600,000 x 10/365)
135,890
Change in level of trade receivables 61,370

Saving in financing costs = 4,910

(61,370 x 8%)

Administrative cost savings 4,450

Total savings 9,360

Calculation of maximum discount:

1,600,000 x 40% x Maximum discount = 9,360

Hence maximum discount = 9,360/(1,600,000 x 0.4) = 0.0146 or 1.46%

The maximum discount that could be offered is therefore 1.46 per cent.

Question 5.

(a) The cash conversion cycle is the receivables' conversion period (RCP) plus
the inventory conversion period (ICP), less the payables' deferral period
(PDP).

3
LECTURE 7
 L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II

RCP = (1,538/ 12,000) x 365 = 47 days

ICP (Raw Materials) = (1634/ 5,800) x 365 = 103 days
ICP (Finished Goods) = (2,018/8,860) x 365 = 83 days
PCP = (1,092/5,800) x 365 = 69 days
CCC = 47 + 103 + 83 - 69 = 164 days or 23.5 weeks

Investment in working capital must be financed: the longer the cash

conversion cycle, the more capital is tied up and the higher the cost to Rowett
plc. The company could reduce the cash tied up by optimising the
components of the cash conversion cycle. So, for example, shortening the
inventory conversion period could reduce the working capital requirement and
increase profitability.

(b) See the answer to Question 3.

(c) Calculations are as follows:

€
Current level of trade receivables = 1,538,000
Trade receivables under factor = 12,000,000 x (40/365) = 1,315,000
Reduction in trade receivables 223,000
€ €
Reduction in financing cost due to lower receivables 17,840
(223,000 x 8%)
Avoided cost of financing new trade receivables w/o factor 105,200
(1,315,000 x 8%)

Cost of financing under factor:

1,315,000 x 8% x 25% = (26,300)
1,315,000 x 10% x 75% = (98,625)
(124,925)
Increased financing cost (1,885)

€ €
Reduction in bad debts = 12m x 0.5% = 60,000
Saving in administration costs = 160,000
Benefits 220,000
Increase in financing cost due to advance (1,885)
Annual fee of factor = 12m x 2% = (240,000)
Costs (241,885)
Net benefit (£21,885)

The finance provided by the factor is an accelerated cash flow derived from
trade receivables. It is therefore not appropriate to use it for a long-term
finance need, such as the purchase of non-current assets. Rather, it should
be used for a short-term need, such as the payment of trade payables or
meeting forecast cash needs. In general, the matching of assets and liabilities
is recommended. That said, permanent current assets should be financed
from a long-term source. Overall, the use of the factor cannot be
recommended as it bring no net benefit.

4
LECTURE 7
 L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II

Phase Test Preparation:

Q1. B (1) and (2) are correct

Statement (3) is the only incorrect one of the three. Surplus cash should not be
invested in ordinary shares as there is a high risk of capital loss.

Q2. E Ordinary Equity shares of FTSE100 companies

Following on from Q1, even if you invest in FTSE100 share which are frequently
traded, there is still a high risk of capital loss.

Q3. B £109,544
Using the Baumol model: Q= √((2 × C × S)/i)
OC = (2 x £1,500,000 x £200/(0.05))½ = £109,544

Q4. B 8.2%
Here the equivalent annual discount is given by:
(40 – 10)/365 X 1% = 8.22%

Q5. B A gain of £6,200

Benefit of discount = 1% x £5m = £50,000
Cost of discount = (60 – 20)/365 x £5m x 0.08 = (£43,836)
Net benefit = £6,164

Q6. D (2) and (3) are correct

In terms of statement (1) the reverse is true. Without recourse means the factor
cannot reclaim bad debts from the company that is using it, hence is comes at a
more expensive price than with recourse. Statements (2) and (3) are both correct.

Q7. A A net benefit of £49,000

Benefit of discount = 0.7% x £42m = £294,000
Cost of discount = (60 – 30)/360 x £42m x 0.07 = (£245,000)
Net benefit = £49,000

5
LECTURE 7