SECOND ROLE OF TREASURY MANAGEMENT:

CASH AND LIQUIDITY MANAGEMENT

A. OPTIMIZATION OF CASH FLOWS

Cash flow optimization can mean a disciplined and strategic approach to
anticipating liquidity shocks and using stockpiling or other windfall
Definition opportunities to maximize wealth accumulation. While company markets
may shift over time, one factor stays the same. It is always necessary to
optimize the financial reports.

To meet short term goals

T reduce borrowing costs
Key Benefits
To increase return on investments
To improve receivables and payables practices

Key Measures By understanding three components of cash flow statement.

Three Components of Cash Flow

The cash flow statement shows the source of cash and helps you monitor incoming and
outgoing money. Incoming cash for a business comes from operating activities, investing
activities and financial activities. The statement also informs about cash outflows, expenses
paid for business activities and investment at a given point in time. The information that you get
from the cash flow statement is beneficial for the management to take informed decisions for
regulating business operations.

1. Operating Activities
Cash flows derived primarily from the principal revenue producing activities of the
entity. In other words, operating activities generally results from transactions and
other events that enter into the determination of net income or loss.
2. Investing Activities
Cash flows derived from the acquisition and disposal of long-term assets and other
investments not included in cash equivalents. This involves transactions involving
non-operating assets.
3. Financing Activities
Cash flows derived from the entity capital and borrowings of the entity. In other
words, these are the results from transactions:
Between the entity and the owners – Equity Financing
Between the entity and the creditors – Debt Financing

Non-Cash Transactions
Acquisition of Asset by assuming directly related liability
Acquisition of Asset by means of issuing share capital
Conversion of Bonds Payable to Share Capital
Conversion of Preference Share Capital to Ordinary Share

Rules for Interest and Dividends

Interest Received Operating
Dividends Received Operating
Interest Paid Operating
Dividends Paid Financing
 Formula for Computation:
Cash Flows from Operating Activities:
Net Income After Tax xx
Add: Depreciation Expense xx
Add: Amortization Expense xx
Add: Decrease in Current Assets xx
Add: Increase in Current Liabilities xx
Add: Loss on Sale of Equipment xx
Less: Gain on Sale of Equipment (xx)
Less: Increase in Current Assets (xx)
Less: Decrease in Current Liabilities (xx) xx
Cash Flows from Investing Activities (xx)
Cash Flows from Financing Activities xx
Increase or Decrease in Cash and Cash Equivalents xx
Add: Cash and Cash Equivalents, Beginning xx
Cash and Cash Equivalents, Ending xx

B. MANAGE INTERNAL CAPITAL MARKETS

An internal capital market is both a capital allocation method and a department within a
company that disperses money to other sections of the company. Unlike an external capital
market, an internal capital market owns the sections of the company to which it is giving money,
which increases control of the funds. One advantage of owning the business units is that it is
much easier to monitor those who receive the money, which may reduce the chances of fraud.
Another advantage is that the department can change the allocation if the money is being used
improperly.

There are two types of capital markets: external and internal. With an external capital market,
the money is loaned to outside people and businesses that are not associated with the company
giving out the money. In an internal capital market, the money is being sent to business units the
company owns, which usually increases control over the funds unless there are unscrupulous
employees attempting to steal the money. An external market makes money by charging
interest on the borrowed money, while an internal market makes money through the projects
and work done with the money.

One advantage to using this approach is that the money is much easier to track than if the
money were being used by entities outside the company. For example, the department can talk
with and check on the business unit’s expenditures to ensure the money is being used properly,
and it can tell the unit how it can and cannot spend the money. The department also will know
exactly who is handling the money and exactly where it is going, which can reduce the chances
of fraud.

C. OPTIMIZATION OF WORKING CAPITAL

Businesses often fail to make the most of net working capital. Leadership teams tend to focus
on the profit and loss statement, frequently at the expense of the balance sheet. We see very
few organizations managing their liquidity with the same rigor as they do their costs. However,
expert management of the cash conversion cycle can rapidly free up liquidity while avoiding
headcount reductions or an operational restructuring.

The WORKING CAPITAL OPTIMIZATION CYCLE is a way of looking at a company’s

receivables, payables and inventory and at how it handles those on a day-to-day basis. The
cycle provides a look at how much working capital it takes to run your business.

There are three aspects: receivables, payables and inventory.

A receivables perspective shows how many days it takes to get paid.
A payables perspective shows how long it takes to pay your vendors.
 An inventory perspective shows you how long it takes to turn over your inventory.

Five Steps to Optimize Working Capital

1. Recognize Net Working Capital as a Source of Value
Accounts receivable, accounts payable and inventory management are the vital
foundations of the balance sheet, yet they are frequently managed as an afterthought
compared with revenues and expenses. It’s understandable: Optimizing NWC is not a
straightforward task. While many of the tools for improving NWC are well-known,
implementing them effectively is difficult. Many organizations already have put into
place measures to improve receivables, payables and inventory with limited success.
There is no one-size-fits-all approach, and guidance on what can be achieved through
best-practice benchmarks is often scarce and industry specific.

2. Understand the Cash Conversion Cycle

It is important to understand details of the cash conversion cycle to determine how
much liquidity is tied up in accounts receivable, accounts payable and inventory.
Leaders following best practices provide visibility at the level of individual customers,
vendors and SKUs, as averaging multiple transactions may obscure particular
problem areas. They evaluate how core processes that influence NWC are running
and assess whether the right disciplines are in place to provide oversight. This review
will highlight the areas that are working well and those that need to be upgraded.

Leaders also collect information from multiple functions to understand the current
state of cash conversion. Involve the commercial teams that manage receivables, the
procurement teams that influence payables, and the operations and supply chain
teams that oversee inventory, as well as business unit or channel leadership.

OPERATING CYCLE
The definition of Operating Cycle is defined as follows:
1. For Merchandising Business – Length of time in which the firm purchase
inventories, sell it and receive cash from sales.

Purchase of Sell the Collect Cash

Inventories Inventories from Sale

Days Inventory or Average Days Accounts Receivable or

Conversion Period + Average Collection Period

2. For Manufacturing – The amount of time elapses from the point when the firm
inputs materials and labor into the production process to the point when cash is
collected from the sale of finished goods.

Input of Materials Sell the Finished Collect Cash

and Labor Goods from Sale

Days Inventory or Average Days Accounts Receivable or

Conversion Period + Average Collection Period

CASH CONVERSION CYCLE

This is the length of time it takes for the initial cash outflows for goods and services
to be realized as cash inflows from the sales.
 This also refers to the length of time between paying for working capital and
collecting cash from sale of inventory.
Length of time the funds are tied up in a working capital.
Basis for how much the company should invest in working capital.

Purchase of Payment for Collect Cash

Inventories Purchases from Sale

Days Accounts Payable or

Cash Conversion Cycle
Average Payment Period

Formula: Cash Conversion Cycle = Operating Cycle – Days Accounts Payable

EXERCISE 1:
Jan. 1 Purchased inventories on account worth P10,000.
Jan. 4 Sold inventories on account worth P12,500
Jan. 6 Paid the accounts payable for inventory purchases.
Jan. 10 Collected Cash from Sales on Account last January 4.

Compute for the following:

1. Days Inventory = 3 DAYS
2. Days Accounts Receivable = 6 DAYS
3. Days Accounts Payable = 5 DAYS
4. Operating Cycle = 9 DAYS
5. Cash Conversion Cycle = 4 DAYS

EXERCISE 2:
LALAMOVE Company is concerned about managing cash efficiently. On the average,
inventories have an age of 90 days, and accounts receivable are collected in 60 days.
Accounts payable are paid approximately 30 days after they arise. EU spends at a
constant rate P 24 million on operating-cycle investments each year.

Compute for the following:

1. How long in days is the normal operating cycle? = 150 DAYS
2. How long in days is the cash conversion cycle? = 120 DAYS

3. Identify Areas of Opportunity

A solid understanding of the existing cash situation allows companies to pinpoint
potential NWC improvements. This step also requires cross-functional
collaboration, given the many daily decisions that affect NWC. To lead this effort,
assemble a team of individuals who have a track record and passion for leading
change. Their task is to identify the “long-list” of opportunities. Some examples:

Managing receivables. Instill rigor in collections management by improving

the processes to monitor collections, track slippage and identify emerging
trends. Feed this analysis back to operations to tailor customer
engagements.
 Managing payables. Improve payment discipline by overhauling internal
supplier payment processes. Improve the timing of supplier payments,
lengthen supplier terms and use the most efficient payment methods.
Managing inventory. Pursue reduction opportunities without compromising
on service levels or risking stock outages. Identify and rationalize
underperforming SKUs to focus on core products and simplify operations.

4. Prioritize Areas of Opportunity

Rank opportunities to increase NWC in order of priority and create an initiative
roadmap. The roadmap should support the company’s strategy and broader
business priorities. Start with actions that can be implemented immediately to
preserve liquidity, while designing more complex longer-term initiatives in parallel.
When creating the roadmap, it’s helpful to organize NWC initiatives in three
groups:

Rapid, “no-regret” actions. These moves free up working capital and can
be executed immediately without detailed justification. They may be a first
step in a broader initiative or a specific action, such as eliminating early
supplier payments.
Discrete, quick-to-execute measures. This group includes actions that can
be accomplished with minimal system or process changes. Their value is
backed by targeted, high-level analysis such as the return on selling slow-
moving inventory, not an in-depth appraisal.
Complex initiatives that warrant careful consideration. These initiatives
may be dependent on the execution of system or process changes. A
detailed analysis can validate the opportunity and indicate when teams need
to seek cross-functional alignment, such as in rationalizing product lines.

5. Launch Net Working Capital Initiatives

Using the roadmap as a guide, assign clear ownership of initiatives, set up a
governance structure to track and monitor progress, and launch the first wave of
actions. Four elements will be instrumental to success:

D. CONFIRMATION AND RECONCILIATION OF RECEIPTS AND

DISBURSEMENTS

1. CONFIRMATION OF RECEIPTS AND DISBURSEMENTS

Confirmation is a form of inquiry. Confirmation process consists in obtaining representations
from third parties and can be undertaken as a result of requests from auditors or the company’s
financial management procedures.

Confirmation is used to confirm the following:

1. Accounts Receivable or Receipts
The accounts receivable confirmation is sent to the customers of the auditee business to
mainly test the existence and valuation of the accounts receivable balance. The
existence assertion test is done to check that the accounts receivable balance in the
balance sheet actually exists. The following are the two types of accounts receivable
confirmation:

a. Positive Accounts Receivable Confirmations

Positive accounts receivable confirmations are confirmations sent to customers
with a requirement to respond to the auditor’s request for information. In this type
of confirmation, the auditor mentions the accounts receivable balance of a
customer in the auditee business’ ledgers and asks them to confirm whether the
balance matches the balance payable to the auditee business in the customer’s
 ledgers. The customer is also requested to mention the balance on their ledgers
in case the balances do not match.

Positive accounts receivable confirmations are superior to negative accounts

receivable confirmations. It is also recommended by standards to use positive
accounts receivable confirmations unless the risk of material misstatements of
the balance is low or the sample population is made up of many small balances.
In case positive accounts receivable confirmations are not returned by the
customers, alternative auditing procedures must be applied to test the assertions
on the accounts receivable balance. However, nonresponses cannot be used as
audit evidence, either positively or negatively.

b. Negative Accounts Receivable Confirmation

The negative accounts receivable confirmation does not require the customer to
respond to the auditor when the balances match. In a negative accounts
receivable confirmation, the customer is only required to respond if the balance
on their ledger does not match the balance on the auditee business’ ledgers. The
negative accounts receivable confirmation is only sent when the auditors
determine the risk of material misstatement is low for the accounts receivable
balance.

This type of accounts receivable confirmation assumes that the balances stated
in the business’ ledgers are valued properly unless otherwise stated by the
customers. However, in case the balances do not agree and the confirmation is
not returned to the auditor, by the customer, for any reason, the balance will still
be considered correct.

2. Accounts Payable or Disbursements

Accounts Payable Confirmation is the confirmation prepared and processed by auditors
to cross-check the amount and information between the client’s records and the client’s
supplier’s records. Those could be included in the outstanding balances and
transactions.

Component of Accounts Payable Confirmation

The accounts payable confirmation should include the following items such as:

Name of the clients – It helps the supplier to know the owner of confirmation.
Client letterhead – It is easy to know the clients’ names as well.
Approval Letter – It is the approval for supplier to release such confidential
information to the auditors.
Signature of the Treasury Manager – It helps the supplier to reply to the correct
auditors.

2. RECONCILIATION OF RECEIPTS AND DISBURSEMENTS

Reconciliation is the process of matching transactions that have been recorded internally
against monthly statements from external sources such as banks to see if there are differences
in the records and to correct any discrepancies.

For example, the internal record of cash receipts and disbursements can be compared to the
bank statement to see if the records agree with each other. The process of reconciliation
confirms that the amount leaving the account is spent properly and that the two are balanced at
the end of the accounting period.

The Reconciliation Process

In most organizations, the reconciliation process is usually automated, using accounting
software. However, since some transactions may not be captured in the system, human
involvement is required to identify such unexplained differences. The basic steps involved when
reconciling transactions include the following:

1. Compare internal records with external records.

The first step is to compare transactions in the internal register and the bank account to
see if the payment and deposit transactions match in both records. Identify any
transactions in the bank statement that are not backed up by any evidence.

2. Identify payments recorded in the internal records and not in the external records
(and vice-versa)
It is possible to have certain transactions that have been recorded as paid in the internal
cash register but that do not appear as paid in the bank statement. The transactions
should be deducted from the bank statement balance. An example of such a transaction
is a check that has been issued but has yet to be cleared by the bank.

A company may issue a check and record the transaction as a cash deduction in the
cash register, but it may take some time before the check is presented to the bank. In
such an instance, the transaction does not appear in the bank statement until the check
has been presented and accepted by the bank.

Conversely, identify any charges appearing in the bank statement but that have not been
captured in the internal cash register. Some of the possible charges include ATM
transaction charges, check-printing fees, overdrafts, bank interest, etc. The charges
have already been recorded by the bank, but the company does not know about them
until the bank statement has been received.

3. Confirm Accounts
The company should ensure that any money coming into the company is recorded in
both the cash register and bank statement. If there are receipts recorded in the internal
register and missing in the bank statement, add the transactions to the bank statement.
Consequently, any transactions recorded in the bank statement and missing in the cash
register should be added to the register.

4. Watch out for bank errors

It is possible to have certain transactions that have been recorded as paid in the internal
cash register but that do not appear as paid in the bank statement. The transactions
should be deducted from the bank statement balance. An example of such a transaction
is a check that has been issued but has yet to be cleared by the bank.

The errors should be added, subtracted, or modified on the bank statement balance to
reflect the right amount. Once the errors have been identified, the bank should be
notified to correct the error on their end and generate an adjusted bank statement.

5. Adjust and Balance both records

The objective of doing reconciliations to make sure that the internal cash register agrees
with the bank statement. Once any differences have been identified and rectified, both
internal and external records should be equal in order to demonstrate good financial
health.

E. TIMELY DISBURSEMENT OF PAYMENTS

Payment practices can indicate how strong or weak your relationship is with your suppliers. You
should agree the terms of payment at the start of all supplier contracts and commit to prompt
payment practice as part of fostering a good relationship with suppliers.

Importance of paying suppliers on time

Help your relationship with suppliers.
Make suppliers keen to work with you.
Increase suppliers' confidence in you as a business partner.
Enable you to negotiate better deals.
Help you avoid late-payment interest charges.
Signal sound financial wellbeing