Copyright: M. S. Humayun 1

Financial Management

Lecture No. 40

Cash Management &

Working Capital FINANCING

Copyright: M. S. Humayun 2

Cash Management• Fundamental Tradeoff:

– Advantage: Need cash for Liquidity, Good Credit Rating, Meet Unexpected Expenses, & To Get Trade Discounts. “Need Cash to Pay the Bills.”

– Disadvantage: BUT, Cash (and even Current Business Accounts in banks) earns NO RETURN (ie. Interest or Markup)

• When Interest Rates are high, the Opportunity Cost of holding cash rises.

– Business Competition forces firms to Sell on CREDIT but that leads to Problems in RECOVERY of Receivables (ie. Bad Debts and Writeoffs).

• “Cash is King” and “Only Cash Can Pay the Bills”

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Cash Management Policies• Interest-based Policy (Minimize Cash holdings when Interest rates are High)

– When Interest Rates are high, the Opportunity Cost of keeping capital in form of Cash (generating zero returns) is higher.

– Try to make Collections quickly and keep as much cash as possible in profit-earning Marketable securities and Investments in Projects

• Cash Flow Synchronization Policy– Use “Billing Cycles” to time the Cash Outflows just after the Cash Inflows– Example: Salaries paid on 3rd of Every Month. Electricity Bill paid on the 18th of

Every Month. Aim for Cash Collections on the 1st and 15th of every month just few days before Cash Outflows.

• Speed up Cash Collection Policy– Business Competition forces firms to Sell on CREDIT but that leads to

Problems in RECOVERY of Receivables (ie. Bad Debts and Writeoffs).– Collection Staff, Letters, Collection Agency– Use Technology: Electronic Wire Transfer, Automatic Debit, Credit Cards

• Float Policy (Keep Track of Cheques Clearance)– Takes 1-2 days in Pakistan for cheque to turn into cash in your account from the

date of deposit.– Aim to make your own Cheque Clearing process quicker (minimize your

Collections Float) than your Supplier’s. That way, you will encash cheques before others can encash yours.

– So, you will have a Positive Net Float in your Bank account. This cash can be used for emergency expenses.

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Cash Dividend Payout Decision• Link between Dividend Policy & Cash Management – Cash

Dividends paid out of Cash !• How should firm decide to pay Cash Dividend based on

Its Impact on Share Price and Firm’s Value? Gordon’s Formula:

– Po = DIV1 / (rE – g) = EPS x (DIV1/EPS) / (rE – (PbxROE) ).• ROE is financial accounting measure of the firm’s ability to internally

generate a return. rE is the return that the firm’s shareholders REQUIRE. Firms try to keep ROE HIGHER than rE.

• If ROE < rE then firm is not generating enough return to meet shareholder requirements so its better to payout the dividend

– If firm makes Dividend payout, share price Po (and Firm Value) will RISE

• If ROE > rE then firm is better off Ploughing the Retained Earnings back into the business and investing in Positive NPV Projects &/or the Firm’s core business. In this case, the best use of internally generated retained earnings is to use them as a cheap source of capital.

– If firm makes Dividend payout, share price (and Firm Value) Po will FALL

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Inventory Management• 3 Types of Inventories: Raw Material, Work in Process, Finished Goods• Issues to Consider in Inventory Management:

– Inventory acquired BEFORE sales so estimates must be accurate. EOQ (Economic Order Quantity) difficult to estimate otherwise:

• Shortfall in Inventories: interruptions in production and loss or sales orders• Surplus Inventories: high carrying costs, wastage, and depreciation

– Case of Eid Time Sales: Using Short-term Finance or Loan to buy extra inventory can be Risky because if you can’t sell it, you will be forced to sell at a Deep Discount. So sell at a loss. Cash trickling in BUT Retained Earnings being wiped out. Not enough cash to pay interest on the loan. Possibly default and bankruptcy.

– Inventory Costs: • Carrying Costs (cost of capital, storage / warehouse rent, insurance premium, wastage)

As high as 20 – 30 % of Inventory value !

• Shipping Costs Generally Less than 5% of Inventory value !• Cost of Running Short Loss of sales, customers, and goodwill difficult to estimate.

• Inventory Management Policies– Technology Based: Dynamic Systems – not only Static EOQ Software for

inventory but Dynamic Computer Software that considers Usage Growth Rates. MRP (Material Resource Planning) and ERP (Economic Resource Planning) Software.

– JIT: Just in Time. Developed by Toyota. Supplies arrive just a few hours before they are used. Inventory and Working Capital is minimized. Improves overall Efficiency.

– Outsourcing: Instead of making all the parts yourself, buy them from outside suppliers at a lower cost and avoid any unionism issues. Example: IT Divisions of Large American MNC’s outsource the writing of computer software to Pakistani software houses.

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A/c Receivables Management• Most firms would prefer to sell for Cash BUT Competition forces

them to sell on Credit. Example: Fabric trading in Pakistan where sellers offer 1 to 3 months credit (and even longer).

• A/c Receivables = Credit Sales per day x Average Number of Days of Credit– Example: Rs 10,000 / day x 30 days = Rs 300,000 of fabric “Stuck in

the market” or “In Rolling” at any given time. • A/c Receivables (other than Profit portion which appears in

Retained Earnings) need to be Financed somehow ie. Short-term loan, trade credit, etc.

• A/c Receivables = Daily Sales x ACP– ACP = Average Collection Period = weighted average days of credit.

Can be obtained from Ageing Schedule (Financial Accounting)– Example: Firm makes 30% of sales on 30 day credit and 70% on 60

day credit. So ACP = (0.3x30) + (0.7x60) = 9 + 42 = 51 Days– Try to Minimize ACP

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Credit Policy

• Factors:– Proper Assessment of Credit-worthiness of each credit customer

(Credit Quality)– Minimize Time (Credit Duration or ACP) and Value (Credit Given)– Creative Credit Terms

• Incentivize Customers to pay cash and to pay quickly– “Sell on 5/10.net 30 basis”. 30 basis Means customer must pay

full cash value within 30 days. 5/10.net means 5% discount for customers who pay within 10 days.

• Impose Carrying Charge on Late Payments– Example: 2% Late payment Charges if bill is not paid within 30

days. Means 24% penal interest per year ! Example. If customer does NOT pay Rs 100,000 bill within 1 month, then he will have to pay Rs 2,000 extra for every month that he is late!

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Working Capital Financing Policies• Sales fluctuate with Nature of Business, Time, Season, State of Economy:

– Economic Growth or Boom: High inventories and Current Assets– Economic Recession: Low inventories and Current Assets

• Never drop to zero because always need minimal “Permanent Current Assets.”

• Total Assets = Fixed + Permanent Current + Temporary Current. – Total assets steadily grow with life of healthy company.– Temporary Current Assets fluctuate with time. Extra Spontaneous Inventory can be financed by

short-term debt financing or loan• 3 Policies for Working Capital Financing (based on Maturity Matching Principle)

– Aggressive• Maximum Short-term financing at low cost (but risk of non-renewal of loan)• Use short-term financing for Temporary Current Assets and even partly to buy Permanent Current Inventory

– Conservative• Maximum Long-term financing. Safe but higher interest costs.• Use long-term financing for Fixed Assets, entire Permanent Assets, and even part of Temporary Current

Assets– Moderate

• Balance of Long and Short-term Financing. Use MATURITY MATCHING PRINCIPLE.• Long Term Financing for Fixed and Permanent Current Assets. Use Short Term Financing for Permanent

Current Assets. Use Spontaneous Current Liability Financing for Temporary Current Assets

• Advantages of Short Term Debt or Loan– Speed of getting finance– Flexibility (not locked in)– Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)– Disadvantage is that cost of debt is uncertain and variable in long run. Non-renewable.

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Graphical View of FinancingMaturity Matching Principle

Match the Maturity of Financing to Usage of Asset

FIXED ASSETS – Usage More than 1 Year

“PERMANENT” CURRENT ASSETS – Usage More than 1 Year

TEMPORARY CURRENT ASSETS – Usage Less than 1 Year

Time (Months)

Value (Rupees)Spontaneous Current Liabilities & Short Term Financing

Short Term Financing & Long Term Financing

Long Term Debt & Equity