Chapter 2

Working capital
management
 Introduction

Working Capital Management: Defined

• Working capital management is the administration and
control of current assets, current liabilities and the
relationship between them.
• Specifically it involves the determination of:
The level of investment in each type of current assets
and consequently the level of total current asset
investment.
The specific sources of financing of working capital and
their proportions
 Working capital management has the following objectives.

1. It helps to maximize the value of a firm by

focusing on maximizing the returns from the
working capital investment in relation to its cost.
2. It helps to minimize, in the long run the cost of
working capital employed by identifying least cost
sources of finance.
3. It helps to control the flow of funds within the
organization so that the firm can meet its financial
obligation and run its operation smoothly
 Working capital management is important for a
number of reasons
• First through a proper working capital management
a firm can avoid liquidity crisis that results in
financial embarrassment to its creditors.

• Second, in many manufacturing and merchandising

firms current assets constitute relatively large
proportion of total assets. This by itself justifies the
close attention and management of working' capital.

• Third, working capital involves firm's day-to-day

transactions and occupies most of the time of
finance personnel.
• Working capital: firm’s investments in current
assets.
• Net working capital: current assets minus current
liabilities.
Components of Working Capital
1. current asset: cash, marketable securities,
accounts receivable and inventory.
2. Current liabilities: accounts payable, banks
loans and notes payable; and portion of long
term debt (due in one year).
• 1. Permanent Working Capital
• There is always a minimum level of current assets,
which is continuously required by the enterprise to
carry out its normal business operations.
 For example, every manufacturing firm has to
maintain a minimum level of raw materials, work-in-
process, finished goods and cash balance.
 This minimum level of current assets is called
permanent working capital or permanent current
assets as this part of working capital is permanently
blocked in current assets.
 2. Variable /Temporary working capital
Temporary working capital or temporary current assets,
on the other hand, are the investment in current assets
that varies with seasonal requirements.
It is the amount of working capital, which is required to
meet the seasonal demands and some special
unforeseen events.
Temporary working capital differs from permanent
working capital in the sense that it is required for short
periods and cannot be permanently employed in the
business.
 Working Capital Investment policy

Investment in current assets has a lower return than

in fixed assets. Current assets have lower risks
(dangers) too.

Therefore, although large investment in current

assets signifies low risk the profitability of this
investment is low as compared to profitability of
investment in fixed assets at the same time.
A business has to strike the right balance between
its investment in current assets and that in fixed
assets.
 Cont’d….
Under these assumptions, the actual level of current
assets within the firm will depend upon the firm’s
evaluation of the risk-profitability tradeoffs. Because
of the following reasons:
 increasing the proportion of current assets to fixed
assets lowers the profitability of assets (rate of
return on assets) but decreases risk (or increase the
liquidity position of a firm to meet unexpected
future funds requirement)
 decreasing the proportion of current assets to fixed
assets increases profitability of assets but it
increases the risk (or reduces the liquidity position
of a firm to meet unexpected future funds
requirement).
• There are three alternative working capital
investment policies. These include
conservative, Maturity Matching Financing
Policy/Strategy and aggressive working
capital investment polices.
 1. Maturity Matching Financing Policy/Strategy

A strategy (policy) to match asset and liability

maturities

Short term sources are used to finance the

temporary current assets.
The permanent current asset and fixed assets are
financed with long term sources
The strategy is to match expected funds inflows with
expected fund out flows.
• Purchase terms = 2/10, n/30
• Sales terms = 2/10, n/30
 2. Conservative Stratrgy(policy)
Suggest that estimated working capital is financed by
long term funds and if there is an emergency you can
use short term funds
Much of the assets requirement is financed with long
term sources
Excess of funds during off-peak season are invested in
short term securities or will be applied for the
repayment of short term obligations.
 Under conservative working capital investment
policy the company holds a relatively large
proportion of its total assets in the form of
current assets
 3. Aggressive strategy (policy)
o Financing the temporary and part of the permanent
current assets with short term sources (borrowing).

o The remaining assets are financed with long term

sources
o Under this policy, the company holds a relatively
small proportion of its total assets in the form of
current assets.
o This policy yields a higher expected profitability and
a higher risk in contrast to conservative policy.
o The firm may be unable to meet its short-term
obligations when due from its current assets.
Factors Affecting Working Capital Requirements
(Determinants of Working Capital)

• There are no set rules or formulae to

determine the working capital requirements
of firms.
• Therefore, an analysis of relevant factors
should be made in order to determine total
investment in working capital. These factors
affect different firm differently.
• Factors that determine working capital
requirement of the firm include:
 1. Nature of Business
• Working capital requirements of a firm are basically influenced
by the nature of its business.
 Public utilities have a very limited need for working capital and
have to invest abundantly in fixed assets. This is because they
may have only cash sales and supply services, not products.
 Thus, no funds will be tied up in debtors and stock (inventories)
 Trading and financial firms have a very small investment in fixed
assets, but require a large sum of money to be invested in
working capital.
 WC is high because they have to stock a variety of goods.
 Manufacturing -WC requirement fall between the two extreme
requirements of trading firms and public utilities.
 2. Production (manufacturing) cycle (and
technology)
• The manufacturing cycle (or the inventory conversion
cycle) comprises of the purchase and use of raw materials
and the production of finished goods.
• It covers the time span from procurement till the time it
becomes finished goods.
• Longer the manufacturing cycles, larger will be the firm’s
working capital requirements.
• E.g. Sugar Factory Vs Beer Factory
 3. Production policy
• A strategy of constant production may be maintained in order
to resolve the working capital problems arising due to
seasonal changes in the demand for the firm’s product.
• A steady production policy will cause inventories to
accumulate during the off-season periods and the
firm will be exposed to greater inventory costs and
risks.
• Thus, if costs and risks of maintaining a constant
production schedule are high, the firm may adopt a
variable production policy, varying its production
schedules in accordance with changing demand.
 4. Credit Policy
• The credit policy of a firm in its dealings with
debtors and creditors influences considerably the
requirements of working capital investment.
• A firm that purchases on credit and sells its
products/services on cash requires lesser amount
of working capital investment.
• On the other hand, a firm buying its
requirements for cash and allowing credit to its
customers shall need larger amount of working
capital investment as very huge amount of funds
are bound to be tied up in accounts receivable.
 5. Business cycle
• During the period of boom, production is more and
WC is high.
• During a period of recession, production decline, the
requirement of WC is low.
6. Marketing policy of the firm (Market and
demand conditions)
Skimming the cream-pricing strategy that a firm should
adopt, i.e., taking the most important thing from the
market.
It is possible when there is no close substitute
(Competition) to the market.
The production is less, you sell less then you will get
higher amount of profit by using a small amount of WC
– Market penetration: - By making the price , sale ,
profit , you will have to produce more so working
capital will be more.
 7. Growth and expansion
• More fixed assets and more working capital
 Product diversification
 Expanding existing product line
 New business line.
 8.Availability of Credit from suppliers
• The working capital requirements of a firm are also
affected by credit terms granted by it suppliers.

• A firm will needless working capital if liberal credit

terms are available to it from suppliers.

• In the absence of suppliers credit, the firm either has to

hold cash or borrow from bank (which is interest
bearing).
 9. Profit level
The net profit is the source of working capital to the
extent that it has been earned in cash.

 Higher profit margins would improve the prospects of

generating more internal funds there by contributing
to the working capital needs.
 10. Level of taxes
The first appropriation of profit is tax.
Taxes may be payable in advance depending on previous
profit.
If tax liability is increased, working capital requirement will
be high.
 Tax evasion: cheating income tax amount. Concealment of
income is tax evasion illegal action
 Tax avoidance: making use of income tax provision for
reducing tax liability.
 12. Price level changes
 During period of inflation to maintain the same level of
requirement additional investment is needed.
 The situation has an effect only at initial position
because the company also sells the product at high
amount. In this case WC increase drastically

13. Operating Efficiency

The operating efficiency of the firm related to the
optimum utilization of resources at minimum costs.
The firm will be effectively contributing in keeping the
working capital investment at a lower level if it is
efficient in controlling operation costs and utilizing
current assets.
Working capital policy: refers to the firm’s basic policies
regarding
1) Target levels for each category of current assets and
2) How current assets will be financed.
Working capital management: involves the
administration of current assets and current liabilities.
The three tasks of working capital management
– speeding up receipts of cash
– delaying payments of cash, and
– investing excess cash
• These three tasks should be done in a manner to
maximize shareholders wealth ,considering time value
of money in to account.
• Current asset Investment Policies
• Relaxed current asset investment( fat cat) policy
– large amounts of cash, marketable securities, and
inventories are carried and where sales are stimulated by
the use of a credit policy that provides liberal financing to
customers and a corresponding high level of receivables.
• Restricted current asset investment (lean and mean)
Policy
– Holdings of cash, securities, inventories, and receivables
are minimized.
• Moderate current asset investment policy.
– Between the two extremes.
Relaxed

Moderate

Restricted
 Operating Cycle:

• The operating cycle begins when the firm receives the

raw materials it purchased and ends when the firm
collects cash payments on its credit sales. Two
measures—days’ sales outstanding and days’ sales in
inventory—help determine the operating cycle.
• Days’ sales in inventory(DSI) shows how long the firm
keeps its inventory before selling it. It is the ratio of
the inventory balance to the daily cost of goods sold.
The quicker a firm can move out its raw materials as
finished goods, the shorter the duration when the firm
holds it inventory, and the more efficient it is in
managing its inventory.
365 days 365 days
Days' sales in inventory  DSI  
Inventory turnover Cost of goods sold / Inventory
• Days’ sales outstanding (DSO) estimates how long it takes on
average for the firm to collect its outstanding accounts receivable
balance. This ratio is also called the average collection period
(ACP).
• An efficient firm with good working capital management should
have a low average collection period compared to its industry.
365 days 365 days
Days' sales outstand.  DSO  
Accounts receivable turnover Net credit sales / Accounts receivable

• The operating cycle is calculated by summing the days’ sales

outstanding and the days’ sales in inventory.

• Operating cycle = DSO+ DSI

 Cash Conversion Cycle:
• The cash conversion cycle is related to the operating
cycle, but it does not start until the firm actually pays
for its inventory.
• The cash conversion cycle is the length of time
between the cash outflow for materials and the cash
inflow from sales.
• To measure the cash conversion cycle, we need
another measure called the day’s payables
outstanding.
• Days’ payable outstanding (DPO) shows how long a
firm takes to pay off its suppliers for the cost of
inventory.
365 days 365 days
Days' payables outstand.  DPO  
Accounts payable turnover Cost of goods sold / Accounts payable
• The cash conversion cycle is then calculated by
summing the days’ sales outstanding and the
days’ sales in inventory and subtracting the
days’ payables outstanding.
• The formula is
Cash Conversion Cycle  DSO  DSI  DPO
• Calculating the Operating and Cash
Conversion Cycles (example):
Item Beginning Ending Average

Inventory $200,000 $300,000 $250,000

Accounts Receivable 160,000 200,000 180,000

Accounts Payable 75,000 100,000 87,500

• Net sales (all credit sales) = $1,150,000

• Cost of goods sold = COGS = $820,000
• Days’ sales in inventory:
• Inventory turnover = COGS / Average inventory =
$820,000 / $250,000 = 3.28 times
• Days’ sales in inventory = 365 / 3.28 = 111.28 days
Days’ sales outstanding:
• Accounts receivable turnover = Credit sales / Average
accounts receivable = $1,150,000 / $180,000 = 6.389
times
• Days’ sales outstanding = 365 / 6.389 = 57.13 days
• Operating cycle = DSO + DSI = 57.13 + 111.28 = 168.41
days
• Days’ payables outstanding:
• Accounts payable turnover = COGS / Average
accounts payable = $820,000 / $87,500 = 9.37
times
• Days’ payables outstanding = 365 / 9.37 =
38.95 days
• Cash conversion cycle = DSO + DSI – DPO =
57.13 + 111.28 – 38.95 = 129.46 days
 Chapter three

Cash and Marketable Security

Management
 Cash and marketable security
management
• Cash is the ready currency to which all liquid
assets can be reduced
• Marketable securities are short term, interest-
earning, money market instruments that are used
by the firm to obtain a return on temporarily idle
funds.
• Cash and marketable securities are held by firms
to reduce the risk of technical in solvency by
providing a pool of liquid resources for use in
making planned as well as unexpected outlays.
 Motives for holding cash and near cash balances

• There are three motives for holding cash and near cash (marketable
securities) balances :
• Transaction motive: A firm maintains cash balances to satisfy the
transaction motive, which is to make planned payments for items such as
materials and wages.

• Safety motive: Balances held to satisfy the safety motive are invested in
highly liquid marketable securities that can be immediately transferred
from securities to cash.
• Such securities protect the firm against being unable to satisfy unexpected
demands for cash.

• Speculative motive: This is a motive of holding cash or near to be able to

quickly take advantage of unexpected opportunities that may arise.
• Speculative motive is the least common of the three motives.
 CASH MANAGEMENT
• The basic objective in cash management is to
keep the investment in cash as low as possible
while still keeping the firm operating efficiently
and effectively (i.e., is reducing the idle cash
amount).

• This goal usually reduces to the dictum (motto)

“collect early and pay late”.
 OBJECTIVES OF CASH MANAGEMENT

• The basic objectives of cash management are two,

these are:
To meet the cash disbursement need (payment
schedule)

To minimize funds committed to cash balance

(Minimization of Idle cash).
• These two objectives are conflicting and mutually
contradictory and it is the task of cash
management to reconcile them.
 1. Meeting the payment schedule

 In the normal course firms have to make payment of

cash on a continuous and regular basis to supplier of
goods, employees and so on. At the same time there
is a constant inflows of cash through collection from
debtors and cash sales.
 Cash is “oil to lubricate the ever turning wheals of
business, without it the process of grinds to stop”.
 A basic objective of cash management is to meet the
payment schedule i.e., to have sufficient cash to meet
the cash disbursement needs of the firm. Keeping
large cash balances however implies a high cost.
Sufficient and not excessive cash can well realize the
advantages of prompt payment of cash.
 2. Minimizing funds committed to cash balance

 High level of cash balance has the advantages of

prompt payment but has high costs.

 A low level of cash may result in not keeping up

payment schedule but has low cost.

 Excessive cash balance reduces profitability as well

as lower cash leads to insolvency. As excess cash or
shortage has its own costs, an optimal cash balance
would have to be arrived.
 MANAGING CASH COLLECTION AND DISBURSEMENT

• Float: Difference between bank cash balance

and book cash balance
• Float= Firm’s bank balance- firm’s book
balance
Float: Difference between bank cash balance and book
cash balance
Float= Firm’s bank balance- firm’s book balance

Disbursement float Collection float

• Checks written by firm • Checks received by the
• Decreased in book cash firm
but no immediate • Increase in book cash
change in bank balance but no immediate
change in bank balance
Net float= disbursement float + collection float

Example:
Disbursement float
XYZ co. currently has birr 1,000,000 on deposit with its
bank. The book balance also shows birr 1,000,000.
Assume that XYZ co. Purchased materials and make
payments by writing a check for birr 100,000
The book balance is immediately adjusted to $ 900,000
when the check is issued.
The bank balance will not decrease until the check is
presented to XYZ’s bank by the supplier or his bank.
Disbursement float = Bank balance – book balance
= 1,000,000 – 900,000 = 100,000
Collection float
Consider the same example above, but instead of
payment, the firm receives a check from a
customer for $ 200,000 and deposits the check at
its bank.
Book balance is adjusted immediately to $ 1,200,000
Bank balance will not increase immediately until
XYZ’s bank present the check to the customer’s
bank and received the amount
Collection float = Bank balance - book balance
= 1,000,000 – 1,200,000 = -200,000
Net float = 100,000- 200,000 =- 100,000
There are a specific techniques and process for speedy
collection of receivable and slowing disbursements.

A. Speeding up collections
Concentration banking: a collection procedure in which payments are
made to regionally dispersed collection centers, then deposited in
local banks for quick clearing.
• Reduces collection float by shortening mail and clearing float.
Lockboxes: a collection procedure in which payers send their payments
to a nearby post office box that is emptied by the firm’s bank several
times daily; the bank deposits the payment checks in the firm’s
account. Reduces collection float by shortening processing float as
well as mail and clearing float.
Direct send: a collection procedure in which the payee presents payment
checks directly to the banks on which they are drawn, thus reducing
clearing float.
Preauthorized checks
Wire transfer.
 B. S-L-O-W-I-N-G D-O-W-N DISBURSMENTS

• Form the firm’s point of view, disbursement float

is desirable, so the goal in managing
disbursement float is to slow down
disbursements as much as possible.

• To do this, the firm may develop strategies to

increase mail float, processing float and
availability float on the checks it writes.
 DETERMINING THE TARGET CASH BALANCE

 The target cash balance involves a trade-off between

the opportunity costs of holding too much cash (the
carrying costs) and the costs of holding too little (the
shortage costs, also called adjustment costs).
 The nature of these costs depends on the firm’s
working capital policy.
• Cash holding
Benefit- liquidity
Cost- interest for gone
Estimating cash balances
• If levels of cash are too high, the profitability of the firm will be
lower than if more optimal balance were maintained.
• Firms can use either subjective approaches or quantitative
models to determine appropriate transactional cash balances.

1. Subjective approaches
2. Quantitative models
Two quantitative models:
• Baumol(BAT) model and
• The Miller-Orr model.
 Baumol(BAT) model
 A model that provides for cost efficient transactional cash
balances.
 Assumes that the demand for cash can be predicted with
certainty and determines the economic conversion quantity
(ECQ/C*).
 It treats cash as inventory item whose future demand for
settling transactions can be predicted with certainty.
 helps in determining a firm’s optimum cash balance under
certainty.
 A portfolio of marketable securities acts as a reservoir for
replenishing transactional cash balances.
• The firm manages this cash inventory on the basis of the cost
of converting marketable securities into cash (the conversion
cost) and the cost of holding cash rather than marketable
securities (opportunity cost). The economic conversion
quantity (ECQ), the cost minimizing quantity in which to
convert marketable securities to cash is

ECQ = 2 x Cost per Conversion x demand for cash

Opportunity cost (in decimal form)
Conversion cost: includes the fixed cost of placing and
receiving an order for cash in the amount ECQ.
• It includes the cost of communicating the necessary
information to transfer funds to the cash account, associated
paper work costs, and the cost of any follow up action.
• The conversion cost is stated as birr per conversion.
Opportunity cost: is the interest earnings per birr given up
during a specified time period as a result of holding funds in a
non-interest earning cash account rather than having them
invested in interest earning marketable securities.
Total cost: is the sum of the total conversion and total
opportunity costs.
• Total conversion =cost per conversion *number of
conversions per period.
• The number of conversions per period
= the period’s cash demand
economic conversion quantity (ECQ).
• The total birr opportunity cost
opportunity cost (in decimal form) *average cash balance.
• The average cash balance is found by dividing ECQ by 2.
The total cost equation is
Total cost = Transaction cost + Holding cost
=(Cost per conversion x number of conversions)+ [Opportunity
cost (in decimal form) x average cash balance]
Example:- The management of Alem Sport, a small distributor of
sporting goods, anticipates birr 1,500,000 in cash outlays
(demand) during the coming year. A recent study indicates that it
costs birr 30 to convert marketable securities to cash. The
marketable securities portfolio currently earns an 8 percent
annual rate or return,
Compute
1. Economic conversion quantity (ECQ)
2. Number of conversions
3. Average cash balance
4. Total cost
Assumptions that are made in the model
1. The firm is able to forecast its cash requirements with
certainty and receive a specific amount at regular intervals.
2. The firm’s cash payments occur uniformly over a period of
time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not
change over time. Cash holdings incur an opportunity cost in
the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it
converts securities to cash.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
2. MILLER- ORR MODEL
• A model that provides for cost efficient transactional cash
balances
• assumes uncertain cash flows and determines an upper limit
(i.e. the maximum amount) and return point for cash balances.
• The return point represents the level at which the cash balance
is set, either when cash is converted to marketable securities
or vice versa.
• Cash balances are allowed to fluctuate between the upper
limit and a zero balance.
• Return point: the value for the return point depends on:
• Conversion costs
• The daily opportunity cost of funds, and
• The variance of daily net cash flows.
 The formula for determining the return point is

Return point= 3 x Conversion cost x Variance of daily net cash flows

3 4 x daily opportunity cost (in decimal form)

 Upper limit: the upper limit for the cash balance is three times the return point.
 Cash balance reaches the upper limit: when the cash balance reaches the upper
limit, an amount equal to the upper limit minus the return point is converted to
marketable securities.
Cash converted to marketable securities = upper limit – return point
Marketable securities converted to cash = return point – zero balance
 Cash Balance falls to zero: when the cash balance falls to zero, the amount
converted from marketable securities to cash is the amount represented by the
return point.
• Example, continuing with the prior example, it
costs Alem sport birr 30 to convert marketable
securities to cash, or vice versa; the firm’s
marketable securities portfolio earns an 8
percent annual return, which is 0.0222 percent
daily( 8%/360 days). The variance of Alem
sport’s daily net cash flows is estimated to be
birr 27,000.