1. FINANCE IN A CANADIAN SETTING Sixth Canadian Edition
Lusztig, Cleary, Schwab

2. Cash and Working Capital Management
CHAPTER
TWENTY-TWO
Cash and Working Capital Management

3. Learning Objectives
1. Explain why the efficient utilization of working capital is so important for companies.
2. Define the difference between short-term and long-term financing.
3. Identify the four motives that influence the proportion of a company’s assets to be held in cash.

4. Learning Objectives
4. Discuss the circular flow of funds in a business and the role of the various types of expenses and incomes.
5. Describe the types of inflows and outflows in a cash budget and how they interact.

5. Introduction
Working capital – encompasses both a firm’s current assets and current liabilities
Net working Capital – the difference between current assets and current liabilities
In this chapter we look at:
the general concepts that guide a firm’s investment in current assets
the management of cash and marketable securities

6. General Concepts of Working Capital Management
Efficient management of working capital is vital to the success of the firm
Different industries require different levels of working capital
Factors important to the management of corporate liquidity include:
good cash flow management
maintaining adequate earnings
good relations with bankers
proper management of receivables, inventories, and capital expenditures

7. General Concepts of Working Capital Management

8. General Concepts of Working Capital Management
Warning signs indicating potential liquidity problems:
a buildup of inventories and declining inventory turnover
increases in debt and debt ratios
increases in costs that cannot be passed on
increases in accounts receivables and collection periods
a decline in net working capital and daily cash flows

9. General Concepts of Working Capital Management
Investment in current assets
current assets tend to grow as sales increase
a firm should increase current assets until the marginal benefit from investment equals marginal costs of carrying the additional assets

10. General Concepts of Working Capital Management
Optimal Investment in Inventory: Marginal Benefits Equal Marginal Costs

11. General Concepts of Working Capital Management
The use of short-term liabilities
Firms may draw on short-term liabilities to finance their operations for three reasons:
1. funds may be needed only temporarily
common for seasonal businesses
2. debt with shorter maturities is often cheaper and easier to obtain than long-term debt
3. long-term financing requires a large amount to be raised at one time

12. General Concepts of Working Capital Management

13. General Concepts of Working Capital Management
Interest rate advantages
Firms perceive an incentive to carry short-term debt over long-term debt because it is cheaper
risks in financing with short-term debt include:
short-term debt has to rolled over continually
unpredictable future interest rates
availability of funds can change

14. General Concepts of Working Capital Management
Stop-gap financing
commonly used as a bridge while preparing for long-term financing
International consideration
foreign exchange exposure and the affect on current assets and liabilities must be considered for firms operating internationally

15. Cash Management
Cash management is concerned with determining the cash balances that will adequately sustain the operation of the company
Proper cash management is crucial to the well- being of any corporation
Profitability and liquidity are important when dealing with cash management
Profitability – when a firm’s revenues exceed the costs incurred in producing the revenues
Liquidity – when a firm can meet its obligations as they come due

16. Motives for Holding Cash
Motives for holding cash include:
Transaction motive – looks at holding cash to meet current transactions
Precautionary motive – focuses on cash balances that are held to provide a cushion for unexpected events such as business declines
Speculative motive – arises when cash is held to take advantage of situations such as sudden price declines or increases in interest rates
Finance motive – deals with the buildup of funds required to finance capital budget appropriations

17. Flow of Funds
Typical Flow of Funds through a Business

18. Cash Budgeting Cash Budget
a forecast of all cash flows into and out of the firm over a given time period
budget time periods can be:
year-to-year
month-to-month
week-to-week
daily
useful for short-term forecasting, external financing, or the temporary investment of excess funds
required by banks as part of loan applications

19. Managing Cash Flow Managing cash flows
to ensure that inflows are received as soon as possible and that payments are not made any sooner than necessary, in order to maximize the firms available cash.
Steps in speeding up collection time include:
prompt invoicing
efficient handling of receipts
Float – the time that elapses from the initial mailing until the funds are available to the recipient

20. Managing Cash Flow Two techniques used to reduce mail float include:
Concentration banking – customers are instructed to make payments to the firm’s closest office, which deposits collection into a local branch bank account
lock boxes – firms establish local, locked post office boxes that customers use as mailing addresses for payments. The local bank is authorized to empty and deposit the funds into the firm’s account
Pre-authorized payment service can be used to eliminate mail floats through a bank automatically debiting a customer’s account on the payment date

21. Optimal Cash Balance Optimizing cash balances
important for large corporations
when firms hold cash they are faced with an opportunity cost
the optimal cash balance is one where the marginal benefits from holding additional cash equals the marginal opportunity costs
firms face precautionary motive related to ensuring the firm has sufficient liquidity in an unpredictable environment

22. Optimal Cash Balance Investment in marketable securities
Excess funds are usually invested in short-term securities that limit risk and are liquid
Factors to consider when investing temporary cash balances
1. The amount to be invested and the period over which the funds are available for investment should be large enough to cover transaction costs
2. The choice of securities
3. The balance between cash holdings and marketable securities needs to be determined based on returns and transaction costs

23. Summary
1. Efficient utilization of working capital is important due to the effects on profitability and liquidity of a firm. Conceptually, the optimal levels of investment in current assets occur when marginal costs equal marginal benefits.

24. Summary
2. The use of short-term liabilities is primarily used to satisfy temporary, seasonal needs. Short-term funding may act as a stop-gap measure while temporarily postponing long-term financing, or while waiting for requirements to have grown sufficiently to warrant a public issue of long-term securities.

25. Summary
3. Cash management is concerned with determining the optimal cash balances that a business should carry. The proportion of assets that a firm should maintain in cash derives from the imposition of the transaction motive, the precautionary motive, the speculative motive, and the finance motive on each other.

26. Summary
4. The flow of funds in a business can be depicted as a circular movement. Funds are committed to expenses of operations, purchases of fixed assets, servicing of outstanding capital, and payment of taxes. As sales are generated and accounts receivable collected, funds flow back to replenish the pool. Investment in inventories and accounts receivable result in time lags in the flow of funds.

27. Summary
5. A cash budget is a detailed plan that lays out projected cash inflows and outflows over a given period. The cumulative net flow determines the cash balance that will be available, or the amount of borrowing that will have to take place.
6. Excess balances of cash may be invested temporarily in marketable securities. Anticipated returns should exceed transaction and management costs.