WORKING CAPITAL MANAGEMENT

WORKING CAPITAL
a) Working capital (also called gross working capital) refers to current assets.
b) Net working capital refers to current assets minus current liabilities.
c) Working capital management refers to the administration of current assets and current
liabilities.

 Target levels of each category of current assets

 How current assets will be financed

d) Liquidity management involves the planned acquisition and use of liquid resources over
time to meet cash obligations as they become due. The firm’s liquidity is measured by
liquidity ratio such as current ratio, quick (or acid test) ratio, cash ratio, etc.

FINANCING CURRENT ASSETS

Current Assets require financing by use of either current funds or long term funds. There are three
major approaches to financing current assets. These are:

a) Matching Approach
This approach is sometimes referred to as the hedging approach. Under this approach, the firm
adopts a financial plan which involves the matching of the expected life of assets with the expected
life of the source of funds raised to finance assets.
The firm, therefore, uses long term funds to finance permanent assets and short-term funds to
finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This approach can be shown
by the following diagram.

1
b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the asset may not be
possible. A firm that follows the conservative approach depends more on long-term funds for
financing needs. The firm, therefore, finances its permanent assets and a part of its temporary
assets with long-term funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds. (Some sources of short-
term funds such as accruals are cost-free). However, short-term funds must be repaid within the
year and therefore they are highly risky. With this in mind, we can consider the risk-return trade
off of the three approaches.

The conservative approach is a low return-low risk approach. This is because the approach uses
more of long-term funds which are now more expensive than short-term funds. These funds
however, are not to be repaid within the year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach. However it is also a high
return approach the reason being that it relies more on short-term funds that are less costly but
riskier.
The matching approach is in between because it matches the life of the asset and the life of the
funds financing the assets.

DETERMINANTS OF WORKING CAPITAL NEEDS

There are several factors which determine the firm’s working capital needs. These factors are
comprehensively covered by A Textbook of Business Finance by Manasseh (Pages 403 – 406).
They however include:

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a) Nature and size of the business.
b) Firm’s manufacturing cycle
c) Business fluctuations
d) Production policy
e) Firm’s credit policy
f) Availability of credit
g) Growth and expansion activities.

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

The finance manager should understand the management of working capital because of the
following reasons:

a) Time devoted to working capital management

A large portion of a financial manager’s time is devoted to the day to day operations of the firm
and therefore, so much time is spent on working capital decisions.

b) Investment in current assets

Current assets represent more than half of the total assets of many business firms. These
investments tend to be relatively volatile and can easily be misappropriated by the firm’s
employees. The finance manager should therefore properly manage these assets.

c) Importance to small firms

A small firm may minimise its investments in fixed assets by renting or leasing plant and
equipment, but there is no way it can avoid investment in current assets. A small firm also has
relatively limited access to long term capital markets and therefore must rely heavily on short-term
funds.

d) Relationship between sales and current assets

The relationship between sales volume and the various current asset items is direct and close.
Changes in current assets directly affects the level of sales. The finance management must
therefore keep watch on changes in working capital items.

CASH AND MARKETABLE SECURITIES MANAGEMENT

The management of cash and marketable securities is one of the key areas of working capital
management. Since cash and marketable securities are the firm’s most liquid assets, they provide
the firm with the ability to meet its maturing obligations.

Cash refers to cash in hand and cash on demand deposits (or current accounts). It therefore
excludes cash in time deposits (which is not immediately available to meet maturing obligations).

3
Marketable securities are short-term investments made by the firm to obtain a return on temporary
idle funds. Thus when a firm realises that it has accumulated more cash than needed, it often puts
the excess cash into an interest-earning instrument. The firm can invest the excess cash in any (or
a combination) of the following marketable securities.

a) Government treasury bills

b) Agency securities such as local governments securities or parastatals securities
c) Banker’s acceptances, which are securities, accepted by banks
d) Commercial paper (unsecured promissory notes)
e) Repurchase agreements
f) Negotiable certificates of deposits
g) Eurocurrencies etc.

CASH CYCLE AND CASH TURNOVERS

Cash Cycle refers to the amount of time that elapses from the point when the firm makes a cash
outlay to purchase raw materials to the point when cash is collected from the sale of finished goods
produced using those raw materials.
Cash turnover on the other hand refers to the frequency of a firm’s cash cycle during a year.

Illustration
XYZ Ltd. currently purchases all its raw materials on credit and sells its merchandise on credit.
The credit terms extended to the firm currently requires payment within thirty days of a purchase
while the firm currently requires its customers to pay within sixty days of a sale. However, the
firm on average takes 35 days to pay its accounts payable and the average collection period is 70
days. On average, 85 days elapse between the point a raw material is purchased and the point the
finished goods are sold.

Required
Determine the cash conversion cycle and the cash turnover.

4
 Solution
The following chart can help further understand the question:

Inventory Conversion period (85 days)

Receivable collection
Payable deferral Period (70 days)
Period (35 days)

Purchase of Payment for the Sale of Collection of

raw materials raw materials Finished goods receivables

Cash conversion cycle = 85 + 70 - 35 = 120

The cash conversion cycle is given by the following formula:

Cash conversion = Inventory conversion + Receivable collection – Payable deferral

Cycle period period period

For our example:

Cash conversion cycle= 85 + 70 – 35 = 120 days

Cash turnover = 360

Cash conversion cycle

360
=
120

= 3 times

Note also that cash conversion cycle can be given by the following formulae:

 inventory receivables Payables Accruals 

Cash conversion cycle= 360    
 costofsales sales Cashoperatingexpenses

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NB: In this chapter we shall assume that a year has 360 days.
SETTING THE OPTIMAL CASH BALANCE
Cash is often called a non-earning asset because holding cash rather than a revenue-generating
asset involves a cost in form of foregone interest. The firm should therefore hold the cash balance
that will enable it to meet its scheduled payments as they fall due and provide a margin for safety.
There are several methods used to determine the optimal cash balance. These are:

a) The Cash Budget

The Cash Budget shows the firm’s projected cash inflows and outflows over some specified period.
This method has already been discussed in other earlier courses. The student should however
revise the cash budget.

b) Baumol’s Model
The Baumol’s model is an application of the EOQ inventory model to cash management. Its
assumptions are:

1. The firm uses cash at a steady predictable rate

2. The cash outflows from operations also occurs at a steady rate
3. The cash net outflows also occur at a steady rate.

Under these assumptions the following model can be stated:

C*  2bT
i

Where: C* is the optimal amount of cash to be raised by selling marketable securities or by

borrowing.
b is the fixed cost of making a securities trade or of borrowing
T is the total annual cash requirements
i is the opportunity cost of holding cash (equals the interest rate on marketable securities or the
cost of borrowing)

The total cost of holding the cash balance is equal to holding or carrying cost plus transaction costs
and is given by the following formulae:

TC  1 Ci  T b
2 C

Illustration
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on marketable securities
is 12% and every time the company sells marketable securities, it incurs a cost of Shs.20.

6
Required
a) Determine the optimal amount of marketable securities to be converted into cash every
time the company makes the transfer.
b) Determine the total number of transfers from marketable securities to cash per year.
c) Determine the total cost of maintaining the cash balance per year.
d) Determine the firm’s average cash balance.

Solution
2bT
a) C*
i

Where: b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%

2x 20x 520,000
C*   Sh.13,166
0.12

Therefore the optimal amount of marketable securities to be converted to cash every time a sale is
made is Sh.13,166.

T
b) Total no. of transfers =
C*

520,000
=
13,166

= 39.5

≈ 40 times

1 T
c) TC  Ci  b
2 C

13,166x0.12 520,000x 20
= 
2 13,166

= 790 + 790 = Shs.1,580

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 Therefore the total cost of maintaining the above cash balance is Sh.1,580.

d) The firm’s average cash balance = ½C

13,166
=
2

= Shs.6,583

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c) Miller-Orr Model
Unlike the Baumol’s Model, Miller-Orr Model is a stochastic (probabilistic) model which makes
the more realistic assumption of uncertainty in cash flows.

Merton Miller and Daniel Orr assumed that the distribution of daily net cash flows is
approximately normal. Each day, the net cash flow could be the expected value of some higher or
lower value drawn from a normal distribution. Thus, the daily net cash follows a trendless random
walk.

From the graph below, the Miller-Orr Model sets higher and lower control units, H and L
respectively, and a target cash balance, Z. When the cash balance reaches H (such as point A) then
H-Z shillings are transferred from cash to marketable securities. Similarly, when the cash balance
hits L (at point B) then Z-L shillings are transferred from marketable securities cash.

The Lower Limit is usually set by management. The target balance is given by the following
formula:


1/ 3
2
Z   3B  L

4i 


and the highest limit, H, is given by:

H = 3Z - 2L

4Z  L
The average cash balance =
3

Where: Z = target cash balance

H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
δ² = variance of net daily cash flows

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Illustration
XYZ’s management has set the minimum cash balance to be equal to Sh.10,000. The standard
deviation of daily cash flow is Sh.2,500 and the interest rate on marketable securities is 9% p.a.
The transaction cost for each sale or purchase of securities is Sh.20.

Required
a) Calculate the target cash balance
b) Calculate the upper limit
c) Calculate the average cash balance
d) Calculate the spread

Solution
 3b² 
1/ 3
a) Z  L
 4i 

 
 3x 20x (2,500)² 
=    10,000
 4x
9% 
 360 

= 7,211 + 10,000 = Sh.17,211

b) H = 3Z – 2L
= 3 x 17,211 – 2(10,000)
= Shs.31,633

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 4Z  L
c) Average cash balance =
3

4 x17,211  10,000
=
3

d) The spread = H–L

= 31,633 – 10,000
= Shs.21,633

Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422 (31,633 – 17,211) in
marketable securities and if the balance falls to Shs.10,000, the firm should sell Shs.7,211(17,211
– 10,000) of marketable securities.

Other Methods
Other methods used to set the target cash balance are The Stone Model and Monte Carlo
simulation. However, these models are beyond the scope of this manual.

CASH MANAGEMENT TECHNIQUES

The basic strategies that should be employed by the business firm in managing its cash are:

i) To pay account payables as late as possible without damaging the firm’s credit rating. The
firm should however take advantage of any favourable cash discounts offered.
ii) Turnover inventory as quickly as possible, but avoid stockouts which might result in loss
of sales or shutting down the ‘production line’.
iii) Collect accounts receivable as quickly as possible without losing future sales because of
high pressure collection techniques. The firm may use cash discounts to accomplish this
objective.

In addition to the above strategies the firm should ensure that customer payments are converted
into spendable form as quickly as possible. This may be done either through:

a) Concentration Banking
b) Lock-box system.

a) Concentration Banking
Firms with regional sales outlets can designate certain of these as regional collection centre.
Customers within these areas are required to remit their payments to these sales offices,
which deposit these receipts in local banks. Funds in the local bank account in excess of a
specified limit are then transferred (by wire) to the firms major or concentration bank.
Concentration banking reduces the amount of time that elapses between the customer’s
mailing of a payment and the firm’s receipt of such payment.

b) Lock-box system.

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 In a lock-box system, the customer sends the payments to a post office box. The post office
box is emptied by the firm’s bank at least once or twice each business day. The bank opens
the payment envelope, deposits the cheques in the firm’s account and sends a deposit slip
indicating the payment received to the firm. This system reduces the customer’s mailing
time and the time it takes to process the cheques received.

MANAGEMENT OF INVENTORIES
Manufacturing firms have three major types of inventories:

1. Raw materials
2. Work-in-progress
3. Finished goods inventory

The firm must determine the optimal level of inventory to be held so as to minimize the inventory
relevant cost.

BASIC EOQ MODEL

The basic inventory decision model is Economic Order Quantity (EOQ) model. This model is
given by the following equation:

2DC o
Q
Cn

Where: Q is the economic order quantity

D is the annual demand in units
Co is the cost of placing and receiving an order
Cn is the cost of holding inventories per unit per order

The total cost of operating the economic order quantity is given by total ordering cost plus total
holding costs.

D
TC = ½QCn + Co
Q

Where: Total holding cost = ½QCn

Total ordering cost = D Co
Q

The holding costs include:

1. Cost of tied up capital

2. Storage costs
3. Insurance costs
4. Obsolescence costs

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The ordering costs include:

1. Cost of placing orders such as telephone and clerical costs

2. Shipping and handling costs

Under this model, the firm is assumed to place an order of Q quantity and use this quantity until it
reaches the reorder level (the level at which an order should be placed). The reorder level is given
by the following formulae:

D
R L
360

Where: R is the reorder level

D is the annual demand
L is the lead time in days

EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:

i) The demand is known and constant over the year

ii) The ordering cost is constant per order and certain
iii) The holding cost is constant per unit per year
iv) The purchase cost is constant (Thus no quantity discount)
v) Back orders are not allowed.

Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in the coming year
which costs Sh.50 each. The items are available locally and the leadtime in one week. Each order
costs Sh.50 to prepare and process while the holding cost is Shs.15 per unit per year for storage
plus 10% opportunity cost of capital.

Required
a) How many units should be ordered each time an order is placed to minimize inventory
costs?
b) What is the reorder level?
c) How many orders will be placed per year?

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d) Determine the total relevant costs.

Suggested Solution:

2DC o
a) Q
Cn

Where: D = 2,000 units

Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days

2x 2,000x50
Q  100units
20

DL
b) R =
360

2,000 x 7
=
360

= 39 units

D
c) No. of orders =
Q

2,000
=
100

= 20 orders

D
d) TC = ½QCn + Co
Q

2,000
= ½(100)(20) + (50)
100

= 1,000 + 1,000

= Sh.2,000

Under the basic EOQ Model the inventory is allowed to fall to zero just before another order is
received.

EXISTENCE OF QUANTITY DISCOUNTS

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Frequently, the firm is able to take advantage of quantity discounts. Because these discounts affect
the price per unit, they also influence the Economic Order Quantity.

If discounts exists, then usually the minimum amount at which discount is given may be greater
than the Economic Order Quantity. If the minimum discount quantity is ordered, then the total
holding cost will increase because the average inventory held increases while the total ordering
costs will decrease since the number of orders decrease. However, the total purchases cost will
decrease.

Illustration
Consider illustration one and assume that a quantity discount of 5% is given if a minimum of 200
units is ordered.

Required
Determine whether the discount should be taken and the quantity to be ordered.

Suggested Solution
We need to consider the saving in purchase costs; savings in ordering costs and increase in holding
costs.

Savings in purchase price:

New purchase price = 50 x 95% = Sh.47.50 per unit

Savings in purchase price per unit = 50 – 47.50
= Sh.2.50
Total units per year = 2,000
Total savings = 2,000 x 2.50 = Sh.5,000

Savings in Ordering Cost

Assuming an order quantity of 200 units per order, the total ordering cost will be:

2,000
(50) = Sh.500
100

Ordering cost if 100 units is ordered

2,000
(100 ) = Sh.1,000
100

Therefore savings in ordering costs = 1,000 – 500 = Sh.500

Increase in holding costs

Holding cost if 200 units are ordered

15
½(200)19.75 = Sh.1,975

holding costs if 100 units are ordered

½(100(20) = Sh.1,000

Increase in holding costs = 1,975 – 1,000 = Sh.975

The Net Effect therefore:

Shs.
Savings in purchases costs 5,000
Savings in ordering costs 500
Total savings 5,500
Less increase in holding costs 975
Net savings 4,525

2DC o
Qd 
Cn

2x 2,000x50
Qd 
19.75

Cn = 15 + 10% x 4.75 = Shs.19.75

The discount should be taken because the net savings is positive. To determine the number of
units to order we recomputed Q with discount Qd.

= 100.6 units

Decision rule:
If Qd < minimum discount quantity, then order the minimum discount quantity.
If Qd < minimum discount quantity, then order Qd.

UNCERTAINTY AND SAFETY STOCKS

Usually demand requirements may not be certain and therefore the firm holds safety stock to
safeguard stock out cases. The existence of safety stock can be illustrated by Figure 5.7.

The safety stock guards against delays in receiving orders. However, carrying a safety stock has
costs (it increases the average stock).

Illustration
Consider illustration one and assume that management desires to hold a minimum stock of 10 units
(this stock is in hand at the beginning of the year).

Required

16
a) Determine the re-order level
b) Determine the total relevant costs

Suggested solution
DL
a) R = S
360

Where: S is the safety stock

2,000
= x 7  10
360

= 49 units

b) The average inventory= ½Q + S

TC = (½Q + S)Cn + D/QCo

2,000
= [½(100) + 10]20 + (50)
100

= 1,200 + 1,000

= Shs.2,200

MANAGEMENT OF ACCOUNT RECEIVABLE

In order to keep current customers and attract new ones, most firms find it necessary to offer credit.
Accounts receivable represents the extension of credit on an open account by a firm to its
customers. Accounts receivable management begins with the decision on whether or not to grant
credit.

The total amount of receivables outstanding at any given time is determined by:

a) The volume of credit sales

b) The average length of time between sales and collections.

Accounts receivables = Credit sales per day x Length of collection period

The average collection period depends on:

17
 a) Credit standards which is the maximum risk of acceptable credit accounts
b) Credit period which is the length of time for which credit is granted
c) Discount given for early payments
d) The firm’s collection policy.

a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The firm following a lenient credit policy
tends to sell on credit to customers on a very liberal terms and credit is granted for a longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a highly selective
basis only to those customers who have proven credit worthiness and who are financially strong.

A lenient credit policy will result in increased sales and therefore increased contribution margin.
However, these will also result in increased costs such as:

1. Increased bad debt losses

2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments

The goal of the firm’s credit policy is to maximise the value of the firm. To achieve this goal, the
evaluation of investment in receivables should involve the following steps:

1. Estimation of incremental operating profits from increased sales

2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs

b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount given. The terms 2/10,
n/30 means that a 2% discount is given if the bill is paid before the tenth day after the date of
invoice otherwise the net amount should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability caused by longer
credit and discount period or a higher rate of discount against increased cost.

c) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of receivables. It can also result
in reduced bad debt losses.

d) COLLECTION POLICY
The firm’s collection policy may also affect our analysis. The higher the cost of collecting account
receivables the lower the bad debt losses. The firm must therefore consider whether the reduction
in bad debt is more than the increase in collection costs.

18
As saturation point increased expenditure in collection efforts does not result in reduced bad debt
and therefore the firm should not spend more after reaching this point.

Illustration
Riffruff Ltd is considering relaxing its credit standards. The firms current credit terms is net 30
but the average debtors collection period is 45 days. Current annual credit sales amounts to
Sh.6,000,000. The firm wants to extend credit period net 60. Sales are expected to increase by
20%. Bad debts will increase from 2% to 2.5% of annual credit sales. Credit analysis and debt
collection costs will increase by Sh.4,000 p.a. The return on investment in debtors is 12% for
Sh.100 of sales, Sh.75 is variable costs. Assume 360 days p.a. Should the firm change the credit
policy?

Suggested Solution
Current sales = Sh.6,000,000
New sales = Sh.6,000,000 x 1.20 = Sh.7,200,000
Contribution margin = Sh.100 – Sh.75 = Sh.25
Sh.25
Therefore contribution margin ratio = x100 = 25%
Sh.100

Cost benefit analysis

Contribution Margin
New policy 25% x 7,200,000 = 1,800
Current policy 25% x 6,000,000 = 1,500 = 300

Credit analysis and debt collection costs (84)

Bad debts
New bad debts = 2.5% x 7,200,000 = 180
Current bad debts = 2% x 6,000,000 = 120 (60)

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Debtors
Cr.period
New debtors = x cr. Sales p.a.
360days

60
= x 7,200 ,000 = 1,200
360

45
Current debtors = x 6,000 ,000 = 750
360
Increase in debtors (tied up capital) 450
Forgone profits = 12% x 450 (54)
Net benefit (cost) 102
Therefore, change the credit policy.

EVALUATION OF THE CREDIT APPLICANT

After establishing the terms of sale to be offered, the firm must evaluate individual applicants and
consider the possibilities of bad debt or slow payments. This is referred to as credit analysis and
can be done by using information derived from:

a) The applicant’s financial statement

b) Credit ratings and reports from experts
c) Banks
d) Other firms
e) The company’s own experience

APPLICATION OF DISCRIMINANT ANALYSIS TO THE SELECTION OF

APPLICANTS
Discriminative analysis is a statistical model that can be used to accept or reject a prospective
credit customer. The discriminant analysis is similar to regression analysis but it assumed that the
observations come from two different universal sets (in credit analysis, the good and bad
customers). To illustrate let us assume that two factors are important in evaluating a credit
applicant the quick ratio and net worth to total assets ratio.

The discriminant function will be of the form.

ft = a1(X1) + a2(X2)

Where: X1 is quick ratio

X2 is the network to total assets
a1 and a2 are parameters

The parameters can be computed by the use of the following equations:

a1 = Szz dx – Sxzdz
Sxx Sxx – Sxz²

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a2 = Szz dx – Sxzdz
Szz Sxx – Sxz²

Where: Sxx represents the variances of X1

Szz represents the variances of X2
Sxz is the covariance of variables of X1 and X2
dx is the difference between the average of X1’s bad accounts and X2’s good accounts
dz represents the difference between the average of X’s bad accounts and X’s good
accounts.

The next step is to determine the minimum cut-off value of the function below at which credit will
not be given. This value is referred to as the discriminant value and is denoted by f*.

Once the discriminant function has been developed it can then be used to analyse credit applicants.
The important assumption here is that new credit applicants will have the same characteristics as
the ones used to develop the mode.

More than two variables can be used to determine the discriminant function. In such a case the
discriminant function will be of the form.

ft = a1x1 + a2x2 + … + anxn

21