All Rights Reserved Ch. 5: 1 Financial Management © Oxford Fajar Sdn. Bhd. (008974-T) 2010 Chapter 5 Cash and Working Capital Management

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Ch. 5: 1

Financial Management© Oxford Fajar Sdn. Bhd. (008974-T) 2010

Chapter 5

Cash and WorkingCapital Management

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Learning Objectives

At the end of this chapter, you should be able to: Explain working capital and the cash conversion

cycle Describe motives for holding cash Describe and analyse the different mechanisms for

managing the firm’s cash collection and disbursement procedures

Identify and compute inventory management costs Apply inventory management models to optimize the

firm’s inventory

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Explain the reasons for granting credit Evaluate credit granting decisions Describe important accounts receivable

management tools Describe the mechanics of different types of short-

term borrowings and evaluate their costs

Learning Objectives (cont.)

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Introduction

Working capital comprises of current assets minus its current liabilities

Current assets comprise….. Current liabilities……..

WC=CA - CL

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Working capital management involves all aspects of the administration of current assets and current liabilities.

Working capital management, hence, covers (but is not limited to) several basic relationships:• Sales impact—must determine the appropriate levels

of receivables and inventories to maintain• Liquidity—must choose the levels of cash and

marketable securities to maintain

Introduction (cont.)

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• Relations with stakeholders—customers are concerned with price, availability, quality and service, goodwill and reputation of a firm. On the opposite end, the firms would also have similar concerns about its suppliers

• Firm’s reputation depends on its ability to efficiently manage its current assets and current liabilities

Introduction (cont.)

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Guiding Principles about Working Capital Finance

Risk return trade-off

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Financing Working Capital

Three (3) approaches may be adopted:

i) Maturity-matching approach

ii) Conservative approach

iii) Aggressive approach

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Maturity-matching Approach

Hedge risk by matching the maturities of assets and liabilities.

Permanent current assets are financed with long-term financing, while temporary current assets are financed with short-termfinancing.

There are no excessfunds.

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Temporary current asset: A subset of a company's current assets that changes according to seasonal fluctuations. For example, a retail store's current inventory may include holiday decorations around Christmas. These decorations would be temporary assets with respect to the remainder of the store's inventory.

Permanent current asset: The current assets a firm needs in order to continue operations. Examples depreciating assets such as computers. These assets are current because they do not remain assets for longer than a year, but they are permanent because they must be replaced with similar assets.

http://financial-dictionary.thefreedictionary.com/Current+Assets

http://financial-dictionary.thefreedictionary.com/Retail

http://financial-dictionary.thefreedictionary.com/Inventory

http://financial-dictionary.thefreedictionary.com/Current+Assets

http://financial-dictionary.thefreedictionary.com/Depreciating

http://financial-dictionary.thefreedictionary.com/Assets

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Conservative Approach

Long-term funds are used to finance both permanent as well as some temporary short-term assets.

When there areexcess funds,they are investedin marketablesecurities.

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Aggressive Approach

Use less long-term and more short-term financing than the conservative approach.

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Cash Management Cycle

Overall measure of effectiveness in managing net working capital.

Main objective is to minimize working capital subject to the constraint that there should be adequate working capital to support the firm’s operations

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Cash Conversion Cycle

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Inventory conversion period is the average time between purchasing inventories and selling the goods:

Cash Conversion Cycle (cont.)

365 daysInventory conversion period X=Cost of goods sold

Inventory

Debtors’/ac receivables collection period is the number of days for debtors to pay from time of sale:

365 daysDebtors' collection period X=Sales

Receivables

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Cash Conversion Cycle

Creditors’/ac payables credit period is the number of days from the time of purchase of materials and labour for goods and the time of payment:

Refer to Example 5.1 of textbook for illustration.

365 daysPayables credit period X=Cost of goods sold

Accounts payable

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Cash Budget

Detailed plan of a firm’s future cash flows An estimation of the cash inflows and outflows for

a firm for a specific period of time in the future Assess whether it has sufficient cash to fulfil its

cash flow requirements in the future and whether excess cash exists

3 main components necessary for creating a cash budget: i) Time period

ii) Desired cash position

iii) Estimated sales and expenses

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General Format of Cash Budget

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Reasons for Holding Cash

Transactions—the need for cash make everyday payments

Precautionary—the need to have cash on hand to meet unexpected needs or unforeseen expenses

Speculative—based on the desire to take advantage of potential profit-making opportunities that require cash

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Transaction Demand Models

Baumol Model The firm can predict its cash requirements with

certainty Cash disbursements are spread uniformly over the

period Interest rate or opportunity cost of funds (holding

cash) is fixed at all times, represented by ‘K’ Firm pays fixed transaction cost each time it

converts securities to cash, represented by ‘F’

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Baumol Model

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Optimal deposit size

Baumol Model (cont.)

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Miller-Orr Cash Model

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Inventory Management

Inventory management ensures that firms have sufficient inventory for production and for sale to customers.

Manufacturing firms carry three types of inventories:

i) Raw materials

ii) Work in progress

iii) Finished goods

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Economic Order Quantity (EOQ)

Total inventory costs = Total carrying costs + Total ordering costs

Average inventory = Q/2

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Economic Order Quantity (EOQ) (cont.)

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Reorder Point

Reorder point = Expected lead time + Safety stock

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Debtors

Sales on credit terms to customers give rise to debtors (accounts receivables)

Level of debtors is determined by the level of sales and credit and collection policies of the firm

Credit Terms Conditions as agreed in the contractual agreement

between the supplier and the customer pertaining to the credit granted to customer

Interpretation of ‘3/10, net 30’

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Debtors (cont.)

Credit standards The criteria to assess customers and determine the

amount of credit and extent of credit period to be granted to debtors

Sources of credit informationInternal sources include: Credit application, including referees Customer’s past history, especially the payment history Information and input from the firm’s sales and

accounting department staff

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Sources of credit information

External sources of information include: Recent years’ financial statements (typically the last

three most recent years)—review of customer’s profitability, financial standing, debt obligations and liquidity

Reports from credit rating agencies e.g. Ratings Agency Malaysia

Credit bureau reports—Central Credit Reference Information System (CCRIS)

Debtors (cont.)

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Five C’s of credit Character—the commitment to meet credit obligations Capacity—the ability to meet credit obligations with

current income Capital—the ability to meet credit obligations from

existing assets if necessary Collateral—refers to the security that underlies assets

if necessary Conditions—includes consideration of general and

industry economic conditions

Debtors (cont.)

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Credit-scoring Models

Credit-scoring models involve the numerical evaluation of customers using scientific approaches.

Score is a number that lenders use to determine the credit risk.

Calculation is based on a mathematical equation that evaluates information in the credit file and compares it to the patterns in millions of other credit files.

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Credit-scoring Models (cont.)

Multi-discriminant analysis (MDA)

Z-score ≥ 3.0: Firm is safe based on these financial figures only

Z-score between 2.7 and 2.99: On alert—should exercise caution

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Z-score between 1.8 and 2.7: Good chance of the company going bankrupt within 2 years of operations from the date of financial figures given

Z-score below 1.80: Probability of bankruptcy is very high

Credit-scoring Models (cont.)

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Other Credit Decisions

Delinquent credit accounts Letter or statement Telephone Personal visits to customers’ premises Collection agencies Legal proceedings

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Other Credit Decisions (cont.)

Changing credit policy Credit policy changes involves altering the terms,

standards or collection practices Typical way to evaluate the net benefit of changing

a credit policy is via the use of the incremental analysis

Refer to textbook—page 108 & 109

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Using Accounts Receivable as Collateral

Accounts receivables (debtors) may be used as collateral to raise short-term financing

The accounts receivable is pledged by the firm as collateral to the lender.

The amount of the loan is a percentage of the receivables pledged.


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Factoring Accounts Receivable Factoring is where a firm sells its debtors at a

discount Involves raising funds against the security of the

firm’s trade debts Basic services are offered:

a) Sales ledger accounting, involving invoicing and collecting debts;

b) Credit insurance, which guarantees against bad debts;

c) Provision of finance


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Factoring Accounts Receivable (cont.) 2 types of factoring service—Non-recourse factoring

and Recourse factoring Non-recourse factoring is where the factoring company

purchases the debts without recourse to the firm selling its accounts receivable.

Recourse factoring, on the other hand, is where the business takes the bad debt risk.

Factoring also provides additional services such as:a) Administration of a firm’s invoicingb) Accounts maintenancec) Debt collections service


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Marketable Securities

Malaysian Government raises short-term financing through the issue of marketable debt instruments.

Forms of Government securities that are available in Malaysia are:a) Malaysian Government Securities (MGS)

b) Malaysian Treasury Bills (MTB)

c) Government Investment Issues (GII)

d) Malaysian Islamic Treasury Bills (MITB)

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Repurchase Agreements- Banks sell market instruments to investors and buy

back those instruments later- Firms can invest in these securities for short periods,

ranging from one day to one year

Negotiable Certificate of Deposits- Receipts certifying that monies have been deposited in

a bank issuing the certificate- Represent high quality financial asset; fetches higher

yield than the comparable time deposit and treasury bills

Marketable Securities (cont.)

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Banker’s Acceptance- Short-term credit investments created by other

firms and guaranteed by a bank Commercial Paper- Short-term unsecured debts issued by firms

Marketable Securities (cont.)

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Trade Creditors

Management of trade creditors involves: Attempting to obtain satisfactory credit from

suppliers/creditors Attempting to extend credit during periods of cash

shortage Maintaining good relations with regular and important

suppliers

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Trade Creditors (cont.)

Source of Short-term Finance Represents another source of short-term finance as

firms make use of short-term trade credit offered by supplier

Trade credit will have a cost Firms may be offered discount for early payment Finance managers therefore face whether to

accept the suppliers’ discount offer for early payment or to forego the discount (and make use of the credit period).

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Costs of foregoing early discount: Estimated using annual percentage rate (APR) or

annual percentage yield (APY)

See Example 5.5 in textbook.

Trade Creditors (cont.)

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Other Forms of Short-term Financing

Bank Overdraft Standby cash flow to cover a firm’s daily working

capital requirement Provided by banks Firms can withdraw funds from the Current Account in

excess of the credit balance up the approved limit set by the bank

Interest Rate = Base Lending Rate (BLR) + Spread

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Other Forms of Short-term Financing (cont.)

Trust Receipts Used by a firm (also know as ‘buyer’) to finance local

purchases and importation of goods Document executed by a customer (pledger of goods

or documents of title) Goods released to the firm by the bank, so that the

firm may sell the goods and pay the proceeds from the sale to the bank

Upon receipt of the TR document, the bank will lend the firm funds to pay the trade creditors/suppliers for the goods purchased.

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Banker’s Acceptance Issuance bill of exchange drawn by a firm to its

order, and accepted by the bank, and payable on a specified date

Another form of short-term financing that allows firms to take delivery of goods from the suppliers faster to meet market demands

In the case of the firm that is a seller/exporter, it can arrange for BA for its customers so that it can have access to immediate funds for working capital.


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Letter of Credit Undertaking by the bank, acting in accordance with

the instructions of the borrower, to pay a stipulated amount of money stated in the letter of credit to a named beneficiary against presentation of stipulated documents and in full compliance of the terms and conditions of the credit.

LC issued by bank to the suppliers acts as a form of guaranteed payment. The supplier will be able to collect the payment when all conditions of the LC are met.


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Letter of CreditTypes of LCs available include: Irrevocable LCs—such LCs cannot be amended and

not cancelled without the agreement of all parties to the LC

Standby LCs—funded only if the buyer does not pay the seller as agreed upon

Revolving LCs—used for regular shipments of the same commodity to the same customer (importer). This means that a credit facility is set up with the LC balances drawn down against the credit facility balance


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Transferable LCs—the first beneficiary can transfer all or part of the original LC to a third party

Assignments of proceeds under an LC—the original beneficiary assigns the proceeds to the end supplier

Back-to-back LCs—original LC that has been received by the firm from its customer, who then uses that LC as security to establish another LC, drawn on the firm in favour of its creditors


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Term Loans

Represent intermediate term debt Duration ranging from 5 to 15 years Usually carries fixed monthly repayments and

interest is pegged to BLR


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Term Loans

Other Charges Compensating balance—amount of money that a

bank may require the firm to maintain in a non-interest bearing account.

Deposit concerned may be used by the bank to off set any unpaid loan owing by the firm to the bank

Has the effect of increasing the Effective Interest Rate on the loan, measured by:


Proceeds

Nominal interest

Documents

All Rights Reserved Ch. 5: 1 Financial Management © Oxford Fajar Sdn. Bhd. (008974-T) 2010 Chapter 5 Cash and Working Capital Management