1. Revise Lecture 23

2. Revise Lecture 23 Reasons for holding cash
Business need to keep a certain amount readily available. The reasons include;
Transaction motive
Finance motive
Precautionary motive
Investment motive

3. Revise Lecture 23
There are two mathematical models that you need to be aware of:
Baumol’s model
Miller-Orr’s model

4. Managing Cash flow Surpluses
Most companies would want to avoid risk on short-term cash surpluses that are invested because the funds will be needed in the near future. Desirable investments would generally be low risk and liquid.

5. Managing Cash flow Surpluses
These could include:
Treasury bills: Short-term government IOUs, can be sold when needed
Term deposits: Fixed period deposits
Certificates of deposits: Issued by banks, entitle the holder to interest + principal, can be sold when needed

6. Managing Cash flow Surpluses
Commercial paper: Short-term IOU issued by companies, unsecured
Long term cash surpluses may be used to fund:
Investments: new projects or acquisitions
Financing: Repay debt, buy back shares
Dividends

7. Managing Cash flow Shortages
Working capital funding policy
Cash shortages can be funded by either long-term finance or short-term borrowings.
3 types of assets
Non-current (fixed) assets
Permanent current assets
Fluctuating current assets

8. Managing Cash flow Shortages
Non-current (fixed) assets: Long-term assets e.g. building, machinery
2. Permanent current assets: Required to meet long-term minimum needs and sustain normal trading activity. e.g. stock, average level of accounts receivable
3. Fluctuating current assets
Vary according to normal business activity. E.g. due to seasonal variations

9. Managing Cash flow Shortages
3 Approaches
Moderate approach
Conservative approach
Aggressive approach

10. Managing Cash flow Shortages
Moderate approach
Long-term funds finance permanent assets. Short-term funds finance non-permanent assets. Maturity of the funds matches the maturity of the assets. A balance between risk & return can be achieved by a moderate approach

11. Managing Cash flow Shortages
Conservative approach Less risky & less profitable than moderate policy. Fixed, permanent current assets, partly fluctuating assets financed by long-term funding

12. Managing Cash flow Shortages
Aggressive approach
Increased risk of liquidity & cash flow problem. Some current assets and all fluctuating current assets financed by short-term sources

13. Which approach is better?
As a general rule, assets yield profits over a long period of time should be financed by long-term funds. This is an application of the matching principle. (Moderate approach).
In moderate approach normally short-term assets partly with short-term funding and partly with long-term funding.

14. Which approach is better?
The likelihood of a company adopting an aggressive approach depends on:
Management attitude to risk
Strength of relationship with the bank providing an overdraft
Ability to raise long-term finance

15. The role of Treasury Management
Treasury management is concerned with liquidity and covers the activities:
Banking and exchange
Cash and currency management
Investment in short-term assets
Risk and insurance
Raising finance

16. The role of Treasury Management
A company must choose between having its treasury management:
Centralized
Decentralized

17. The role of Treasury Management
Advantages of Centralized
Avoid duplication of skills
Can borrow / invest in bulk (better rates given)
Better exchange rate management
Potential to net off and therefore reduce to be borrowed and hence charged

18. The role of Treasury Management
Advantages of Decentralized
Greater autonomy leads to greater motivation.
Individual companies will manage their cash balances more attentively if they are responsible for them, rather than simply remitting them up to head office.
Local operating units have a better feel for local conditions than head office and can respond quickly to local development

19. Stock
How to manage stock?

20. How to manage stock?
Stock (Inventory) management has traditionally been about minimising the total cost of stock without running the risk of stock-outs.

21. How to manage stock? Different models can be used for stock management
ABC model / system
Economic order quantity model
JIT (just-in-time)

22. ABC model
The stock days ratio gives an overview of a company’s overall inventory position and is a useful method of monitoring a company’s overall stock position.
But major companies may well have thousands of items in stock and will want to calculate how much stock to hold of each individual item.

23. ABC model
A simple stock classification system called an ABC system is often used to achieve this:
A = High value stock items, requiring careful stock control using sophisticated methods such as EOQ
B = Medium value stock items, as above but with less frequent review

24. ABC model
C = Low value stock items, aim to keep a continuous availability

25. Economic order quantity model
The level of inventory that minimises costs can be established by the economic order quantity model.
This model analyses how to minimises the total stock related costs of a company
For businesses that do not use JIT, there is an optimum order quantity for inventory items, known as the EOQ.

26. Economic order quantity model
The aim of the EOQ model is to minimise the total cost of holding and ordering inventory.
When the re-order quantity chosen minimises the total cost of holding and ordering, it is known as the EOQ

27. Economic order quantity model
This model analyses how to minimise the total stock related costs of a company. Stock related costs are:
Holding Costs
Warehouse
Insurance
Obsolete
Opportunity cost of capital

28. Economic order quantity model
Ordering Costs: Admin & delivery costs

29. Economic order quantity model
EOQ formula

30. Economic order quantity model
Example:
Demand is 150 units per month
Purchase cost per unit Rs25
Fixed order cost Rs32
Holding cost 18% p.a.
Required:
Calaculate the economic order quantity - EOQ

31. Solution

32. Economic order quantity model
Assumptions:
Demand and lead time are constant and known
Purchase price is constant
No buffer inventory held (not needed)

33. Economic order quantity model
Lead time: The lag (time) between when an order is placed and the item is delivered
Buffer stock : The basic level of stock kept for emergencies. A buffer is required because both demand and lead time will fluctuate and predictions can only be based on best estimates

34. Economic order quantity model
EOQ model drawbacks
Assumes 0 lead times, and 0 bulk purchase discounts
Ignores the possibility of supplier shortages or price rise
Ignores fluctuations in demand
Ignores the benefit of holding stock to customers