Unit 12: Working Capital Management - Subjective Questions

Working capital represents the funds invested in the short-term assets required for the day-to-day operations of a business.

• Gross working capital: The total investment in current assets, such as cash, inventory, marketable securities, and receivables.
• Net working capital: The excess of current assets over current liabilities. It is calculated as:

A positive net working capital indicates that the firm is generally capable of meeting its short-term obligations, whereas a negative amount may indicate liquidity pressure.

The principal objective of working capital management is to maintain an appropriate balance between liquidity and profitability.

Its major objectives are:

• Ensuring that the firm can pay its short-term obligations on time.
• Maintaining sufficient inventory to support uninterrupted production and sales.
• managing receivables so that credit sales generate profit without creating excessive bad debts.
• Avoiding unnecessary investment in idle current assets.
• Minimizing the cost of short-term financing.
• Improving the firm's profitability by using current assets efficiently.

An effective policy provides adequate liquidity while avoiding excessive working capital that earns little or no return.

Working capital investment policies determine the level of current assets maintained relative to sales.

• Conservative policy: The firm maintains a high level of cash, inventory, and receivables. Liquidity is high and operating risk is low, but profitability may decline because substantial funds are tied up in low-return assets.
• Aggressive policy: The firm maintains a low level of current assets. This can increase profitability but also raises liquidity, stockout, and default risks.
• Moderate policy: The firm maintains current assets at a level between the conservative and aggressive alternatives. It seeks a reasonable balance between risk and return.

The appropriate policy depends on sales stability, access to finance, operating conditions, and management's risk tolerance.

The policies differ in the way permanent and temporary current assets are financed.

A conservative policy provides greater safety but may reduce profitability. An aggressive policy can lower financing costs and improve returns, but it exposes the firm to greater refinancing and liquidity risks.

Under the matching or hedging approach, the maturity of each financing source is matched with the expected life of the asset being financed.

• Fixed assets and permanent current assets are financed with long-term funds.
• Temporary or seasonal current assets are financed with short-term funds.
• Financing is scheduled to mature when the related assets are converted into cash.

For example, seasonal inventory expected to be sold within three months may be financed with a three-month bank loan. This approach balances risk and financing cost. However, exact matching may be difficult because cash flows and asset lives are uncertain.

The risk-return trade-off arises because decisions that increase liquidity often reduce profitability, while decisions that improve profitability may increase risk.

• Maintaining high current assets lowers the risk of cash shortages, stockouts, and missed payments.
• However, excess cash and inventory generally produce lower returns than long-term productive assets.
• Maintaining low current assets may improve return on investment by reducing idle resources.
• A low current-asset level increases the risk of disrupted operations, lost sales, and insolvency.
• Greater reliance on short-term financing may reduce cost but increases refinancing and interest-rate risks.

Therefore, management must select a working capital level that maximizes firm value rather than simply maximizing liquidity or short-term profit.

Assuming sales remain constant, an increase in current assets usually has the following effects:

• Liquidity increases because more resources are available to meet short-term obligations.
• Operating risk decreases because the firm has larger cash, inventory, and receivables buffers.
• Profitability may decrease because current assets generally earn lower returns than fixed assets.

A reduction in current assets normally produces the opposite effects:

• Liquidity declines.
• The risk of cash shortages, stockouts, and lost sales rises.
• Profitability may increase because fewer funds are invested in low-return assets.

The relationship is not unlimited: reducing current assets below an efficient level may disrupt operations and ultimately lower both sales and profit.

The operating cycle is the time between the purchase of inventory and the collection of cash from customers:

The cash conversion cycle measures the period for which the firm's own funds are committed to operations:

A shorter cash conversion cycle generally reduces working capital requirements and financing costs. It can be shortened by managing inventory efficiently, collecting receivables faster, or using supplier credit appropriately. Excessive reductions, however, may create stockouts, harm customer relationships, or damage supplier confidence.

A business holds cash for several motives:

• Transaction motive: To meet routine payments such as wages, purchases, taxes, and operating expenses.
• Precautionary motive: To deal with unexpected cash requirements, delayed collections, or emergencies.
• Speculative motive: To take advantage of profitable opportunities, such as purchasing materials at a temporary discount.
• Compensating-balance motive: To maintain minimum bank balances as part of a lending or service arrangement.

Holding cash improves liquidity, but excessive cash has an opportunity cost because it could otherwise be invested in income-producing assets.

Cash management aims to ensure that sufficient cash is available when required while minimizing idle balances and financing costs.

Its major components include:

• Cash planning: Forecasting future cash inflows and outflows.
• Collection management: Accelerating customer payments and reducing collection delays.
• Disbursement management: Scheduling payments efficiently without damaging creditworthiness.
• Short-term investment: Investing temporary surplus cash in liquid, low-risk securities.
• Short-term borrowing: Arranging finance for temporary cash deficits.
• Cash control: Monitoring bank balances, preventing fraud, and reconciling records.

Successful cash management maintains liquidity while improving the return earned on surplus funds.

A cash budget is a forecast of cash receipts, cash payments, and cash balances over a specified period.

It is prepared through the following steps:

1. Estimate the opening cash balance.
2. Forecast cash receipts from cash sales, collection of receivables, asset sales, and other sources.
3. Forecast cash payments for purchases, wages, overheads, taxes, capital expenditure, interest, and dividends.
4. Determine net cash flow:

5. Calculate the preliminary closing balance:

6. Add borrowing or investments required to maintain the target balance.

The budget identifies expected surpluses and shortages, supports financing decisions, and improves control over liquidity.

The Baumol model applies the economic-order-quantity principle to cash management. It assumes predictable cash usage, a constant transaction cost, a constant opportunity cost, and periodic conversion of marketable securities into cash.

Let:

• = total cash required during the period
• = fixed transaction cost per conversion
• = opportunity cost of holding cash
• = cash obtained in each conversion

Average cash balance is , while the number of conversions is . Total cost is:

Differentiating with respect to and setting the result equal to zero gives:

Therefore, the optimal transfer amount is:

The model minimizes the combined opportunity and transaction costs of holding cash, although its assumptions may be unrealistic when cash flows are uncertain.

The Miller-Orr model is designed for firms whose daily net cash flows fluctuate unpredictably. It establishes three control points:

• Lower limit: The minimum acceptable cash balance selected by management.
• Upper limit: The maximum balance before surplus cash is invested.
• Return point: The target balance to which cash is restored after reaching either control limit.

When cash reaches the upper limit, the firm invests enough cash to return to the target. When cash reaches the lower limit, it sells marketable securities or borrows enough to restore the target balance. No action is taken while cash remains between the limits.

The model is appropriate when cash flows are uncertain and random. It explicitly considers transaction costs, cash-flow variability, and the opportunity cost of holding cash.

Float is the difference between the cash balance recorded in a firm's books and the balance shown by its bank.

• Collection float: The delay between a customer making a payment and the funds becoming available to the firm. It may include mailing, processing, and bank-clearing delays.
• Disbursement float: The delay between the firm recording a payment and the bank deducting it from the firm's account.
• Net float: The difference between disbursement float and collection float:

A firm seeks to reduce collection float through electronic payments, concentration banking, and lockbox systems. Disbursements should be scheduled efficiently, but the firm must not deliberately issue payments without sufficient funds.

A firm should evaluate the following factors when selecting marketable securities:

• Safety: Preservation of principal and low default risk.
• Liquidity: Ability to convert the investment into cash quickly without significant loss.
• Maturity: Alignment of the security's maturity with the expected need for cash.
• Yield: Return earned after considering risk, transaction costs, and taxes.
• Marketability: Availability of an active secondary market.
• Price risk: Possibility that interest-rate changes will reduce market value.
• Diversification: Avoidance of excessive exposure to one issuer or instrument.

Because surplus cash primarily serves a liquidity purpose, safety and liquidity usually receive priority over maximum yield.

A credit policy is the set of principles used to decide which customers receive credit, how much credit they receive, and how collections are managed.

Its main components are:

• Credit standards: Minimum financial strength and creditworthiness required from customers.
• Credit period: Time allowed for payment.
• Cash discount: Reduction offered for early payment, such as terms of , net .
• Credit limit: Maximum outstanding balance permitted for a customer.
• Collection policy: Procedures used to monitor accounts and recover overdue amounts.

A liberal policy may increase sales but also increases receivables investment and bad-debt risk. A restrictive policy reduces those risks but may result in lost sales.

The five Cs of credit provide a framework for assessing a customer's ability and willingness to pay:

• Character: The customer's honesty, payment history, and willingness to meet obligations.
• Capacity: The ability to generate sufficient cash flow to repay credit.
• Capital: The customer's financial strength, net worth, and level of owner investment.
• Collateral: Assets available as security if the customer fails to pay.
• Conditions: Economic, industry, and transaction-specific conditions affecting repayment.

The evaluation may use financial statements, credit reports, trade references, bank references, and previous payment behavior. No single factor is sufficient; the overall credit decision should reflect all relevant evidence.

A proposal to relax credit standards should be accepted only if its incremental benefits exceed its incremental costs.

The analysis should include:

1. Incremental contribution from additional sales:

2. Additional investment in receivables: A longer collection period or higher credit sales increases funds tied up in receivables.
3. Required return on additional investment:

4. Incremental bad-debt losses.
5. Incremental collection and administrative costs.
6. Potential effects on customer retention and future sales.

The proposal is financially desirable when:

Extending the credit period gives customers more time to pay and may increase sales. However, it also increases the average collection period, investment in receivables, financing cost, and possibly bad debts.

Offering or increasing a cash discount may:

• Encourage customers to pay earlier.
• Reduce the average collection period and receivables investment.
• Lower collection expenses and bad-debt losses.
• Increase sales if the terms are attractive.
• Reduce revenue because customers who take the discount pay less.

For terms stated as , net , the approximate annual cost to a customer of not taking the discount is:

Management should change the terms only when the resulting incremental benefit exceeds discount, financing, and risk-related costs.

The principal techniques for monitoring and controlling receivables include:

• Average collection period: Measures the average time taken to collect credit sales:

• Receivables turnover ratio: Measures how frequently receivables are collected:

• Aging schedule: Classifies receivables according to how long they have remained unpaid.
• Days sales outstanding: Compares actual collection performance with credit terms.
• Collection effectiveness measures: Track overdue balances and recovery rates.
• Customer-level review: Identifies deteriorating payment behavior or excessive credit exposure.

These tools should be compared with past results, industry standards, and the firm's credit terms because aggregate ratios alone can conceal problem accounts.