1. Revise Lecture 22

2. Revise Lecture 22 Objectives of working capital? Cash operating cycle?
Overtrading?

3. Objectives of WC Management
The two main objectives of working capital management are:
To increase the profits of a business
To provide sufficient liquidity to meet short term obligations as they fall due

4. Cash Operating Cycle
The cash operating cycle also known as the working capital cycle is the period of the time between the outflow of cash to pay for raw material and the inflow of cash from customers.
The cash operating cycle can be used to determine the amount of cash needed at any sales level and to identify the possibility of a cash short fall if sales rise too rapidly using the sales / net working capital ratio

5. Overtrading
If a business fails to plan how to supply its forecast level of cash flow need, it will be in danger of overtrading.
Overtrading is where a business has inadequate cash to support its level of sales.

6. Cash
The Management of cash?

7. The Management of Cash
As business grows, its working capital funding needs to also grow. A key question for a treasury department is how to fund this working capital growth.
This is complicated by the fact that some current assets are permanent e.g. a certain amount of stock and debtors are always present and some are fluctuating due to seasonal fluctuation in business

8. The Management of Cash Reasons for holding cash
Business need to keep a certain amount readily available. The reasons include;
Transaction motive
Finance motive
Precautionary motive
Investment motive

9. The Management of Cash Transaction Motive
Cash required to cover day-to-day expenses, e.g. payroll, payment of suppliers etc
Finance Motive
Cash required to cover major items such as the repayment of loans and the purchase of non-current assets

10. The Management of Cash Precautionary motive
Cash held to give a cushion against unplanned expenditure (the cash equivalent of buffer stock)
Speculative motive
Cash kept available to take advantage of market investment opportunities

11. The Management of Cash Running out Cash
The cost of running out of cash can have serious operational repercussions;
Settlement discounts for early payment are unavailable
Trade suppliers refuse to offer credit, charge higher prices or downgrade the priority with which orders are processed
If wages are not paid on time, industrial action may well result, damaging production in the short-term and relationships.

12. The Management of Cash
Cash Forecasts and Cash Budgets Cash Forecasts A cash forecasts is an estimate of cash receipt and payments for a future period under existing conditions Cash Budgets A cash budget is commitment to a plan for cash receipts and payments for a future period.

13. Cash Management Models
Cash management models are aimed at minimizing the total costs associated with movements between;
A current account (very liquid but not earning interest)
Short-term investments (less liquid but earning interest)

14. Cash Management Models
Mathematical Models
The models are devised to answer the questions;
At what point should funds be moved?
How much should be moved in one go?

15. Cash Management Models
There are two mathematical models that you need to be aware of:
Baumol’s model
Miller-Orr’s model

16. Cash Management Models
Baumol Model (The Baumol cash management model) Baumol noted that cash balances are very similar to inventory levels and developmed a model based on the economic order quantity (EOQ) The model suggests that when interest rates are high, the cash balance held in non-interest bearing current accounts should be low.

17. Cash Management Models
The Baumol model is an adaptation of the EOQ model to manage cash. It assumes that cash is used at a steady rate during the year, which will often not be the case.
The Economic Order Quantity of Cash =
2*annual cash required*cost of ordering cash/Net interest cost of holding cash

18. Cash Management Models
The formula calculates the amount of funds to inject into the current account or to transfer into short-term investments at one time.
Cash management model indicate or idea that optimum amount of cash or optimum cash balances that a company should hold and suggests optimum amount to be transferred regularly from investments to current account

19. Cash Management Models
Example:
A division requires Rs1.5m per year, cash use is constant throughout the year.
Required:
What is the optimal economic quantity of cash transfer into this division’s sub account if ordering costs are Rs150 per transaction and the interest lost on the funds transferred is 4.5% pa?

20. Solution

21. Cash Management Models
Assumptions
Cash use is steady and predictable
Cash inflows are known and regular
Day-today cash needs are funded from current account
Buffer cash is held in short-term investments

22. Miller-Orr-model – Cash management
Another cash management model is the Miller-Orr-model which recognize that cash inflows and outflows vary considerably on a day to day basis (unlike the Baumol model).
This is clearly more realistic.
The Miller-Orr model controls irregular movements of cash by the setting of upper and lower limits on cash balances.

23. Miller-Orr-model – Cash management
Formulas Miller-Orr model
Spread
Upper limit
Return Point

24. Formulas

25. Miller-Orr model - Example
The minimum cash balance of Rs20,000 is required at Miller-Orr company and transferring money to or from the bank costs Rs50 per transaction. Inspection of daily cash flows over the past year suggests that the standard deviation is Rs3000 per day and hence the variance (SD squared) is Rs9million. The interest rate is 0.03% per day.

26. Miller-Orr model - Example
Required:
The spread between the upper & lower limits
The upper limit
The return point

27. Solution

28. Solution

29. Cash Management How to managing cash flow surpluses?
How to managing cash flow shortages?
What is the role of treasury management?