q

4
Cash management and

working capital finance

4
Learning objectives
Oncompletion
ofthischapter
youshould
beableto:

Syllabus
reference
Managementofinventories,
receivables,
payables andcash(continued)
• Explain
thevarious
reasons forholding
cash,anddiscussandapplythe C2(f)
useofrelevant
techniquesinmanaging cash,including:
- preparingcashflowforecaststodeterminefuture
cashflowsandcash
balances
- assessingthebenefits
ofcentralised
treasurymanagementandcash
control
- cashmanagement models, suchastheBaumol andtheMiller-Orr
G H

models
- investing
short-term.
Determining
working capitalneedsandfunding strategies
• Describe
anddiscuss thekeyfactors indeterminingworkingcapital C3(b)
funding
strategies,
including:
- thedistinction
between permanent andfluctuatingcurrentassets
- therelative
costandriskofshort-term andlong-term finance
- thematching principle
- therelative
costsandbenefits ofaggressive,conservative
and
matchingfunding policies
- management attitudestorisk,previous
fundingdecisions
&
organisation
size.
4
Exam context
Thischaptercoversissuesrelatingtoliquidity
andthefinance ofworkingcapital,whicharepart
ofSectionC ofthesyllabus (Working capitalmanagement)andcompletes thissyllabussection.
Likethepreviouschapter,thissyllabusareaisexaminableinallsections
oftheexamandexam
questionswon’tjustinvolve
calculations(eginsectionC partofanexamquestion mayaskyouto
discusstypesofworking capitalfunding strategies
ortoexplainthemeaning ofa numericalcash
flowanalysis
thatyouhaveperformed).

Page 93 of 641
 q
4
Chapter overview

Workingcapital finance

Cashmanagement Mathematical
models

Motives
forholding
cash Baumol

Cash
flow
forecasting Miller-Orr

Easing
cash
shortages

Managing
cashsurpluses

Working
capitalfinance Treasury
management

G
Asset
types Functions H

Aggressive
financing
strategy Centralised

Conservative
financing
strategy Decentralised

72 Financial
Management
(FM)

Page 94 of 641
 q
1 Cash management

PER alert
Performance objective
10requires
youto‘prepare
andmonitoranorganisation’s
cashflow,
creditfacilities
andadvise
onappropriate
actions’.
Thischapter
covers
themanagement of
cashandcashflowforecasts.

Wesawintheprevious chapter thatworking

capitalmanagementhastwomainobjectives:
(a) Toincrease
theprofits ofa business
(b) Toensuresufficient
liquidity
tomeetshort-term
obligations
astheyfalldue
Thischapter
mainly focusses onliquidity
andcoverstheimportance
ofcashflowmanagement
anddifferent
strategies
thatcanbefollowed toprovideworking
capitalfinance
1.1 Motives for holding cash
There
arethreemainmotives
forholding
cash.
Transactionsmotive Precautionarymotive Speculationmotive
Abusiness primarily
needsto Cashmayalsobeneeded to Somebusinessesholdsurplus
plantomaintainsufficient meetunexpected occurrencescashtotakeadvantage of
cashtomeetitsforecast (eganunforeseen downturn attractiveinvestment
transactions
egpaying insales,ordisruption to opportunities
ifthesearise.
suppliers,
employeesetc. production). Forexample,theopportunity
Cashrequirementstocover Thisoftenmeans thata totakeoveranothercompany
thismotivecanbeplanned businesswillarrange an atanattractive
price.
usinga cashflowforecast. overdraftfacility,orshort-
G
terminvestments whichcan H

easilybeconverted intocash
(discussedinsection 1.4).

However,
holding
cash(ornearequivalents
tocash)hasa cost:thelossofprofitswhichwould
otherwise
havebeenobtained
byusingthefundsinanother way.So,asever,thefinancial
manager
musttrytobalance
liquidity
withprofitability.
1.2 Cash flow forecasting

Cashflowforecast:
Adetailed
forecast
ofcashinflows
andoutflows
incorporating
both
KEY revenue
andcapitalitems.
TERM
Cashflowforecasts
willbeprepared
continuously
during
theyearandwillallowa business
to
planhowtodealwithexpectedcashflowsurpluses
orshortages.
1.2.1 Formatofcashflowforecast
Acashflowforecastwilltabulateestimatedfuture cashreceiptsandpayments insucha wayas
toshowtheforecastcashbalance ofa businessatdefined intervals.
Thereisno‘set’format
that
youarerequiredtousebutitissensible tofollowtheseguidelines:
(a) Havetwoseparate sections,oneforcashinflows andoneforcashoutflows
(b) Don’treproduce
theforecast separatelyforeachtimeperiod (instead
adda newcolumn for
eachtimeperiodbeinganalysed)
(c) Finish
eachcolumn bynetting offthecashflowfortheperiod andaddingittocashbrought
forwardtocreatea finalcashflowcarriedforward figure.
Thiscanbedoneeasilyintheexam
usingthespreadsheet functionality
availableintheconstructiveresponseworkspace.

4:Cashmanagement
andworking
capital
finance 73

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 q
Hereisanexample
ofa cashforecast,
illustrating
a sensible
format.
CASHFORECASTFORTHETHREEMONTHS
ENDED31MARCH20X1
January February March
Cashreceipts
Salesreceipts
(W1) X X X
Issueofshares X
Cashpayments
Purchase
payments
(W2) (X) (X) (X)
Dividends/Taxes (X)
Purchase
ofnon-current
assets (X)
Wages (X) (X) (X)
Cashsurplus/deficit
formonth X (X) X
Cashbalance,
beginning X X (X)
Interest
onopening
cash
balance X X (X)
Cashbalance,
ending X (X) X
Working
January February March
G
1. Timing
ofsalesreceipts H

Revenue
fromsales1monthago(assuming
1- FromDec FromJan FromFeb
monthcreditperiod) sales sales sales
2. Timing
ofsupplier
payments
Supplier
invoices
from2 months
ago(assuming FromNov FromDec FromJan
2-monthcreditperiod) purchases purchases purchases

Examfocus point
Intheexamyouwillneedtothinkcarefully
abouttheexpectedtimingofreceipts
and
paymentsofcashduringtheperiodandwhether
a costisa cashitemegdepreciation.

Activity1:Cash forecast

Benisa wholesalerofmotorcycle
helmets.
Itis1January20X2.
Creditsalesinthelastquarter
of20X1wereasfollows:
Helmets
October 2,000
November 2,000
December 2,500

74 Financial
Management
(FM)

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 q
Hiscreditsalesinthefirstquarter
willbeasfollows:
Helmets
January 3,000
February 5,000
March 4,500
Customers aregiven60days’creditandtheaverage sellingpriceis$10,a priceriseof$1is
planned inFebruary. Hisbiggestcustomer,Mickster,
isgivena 2%discount forpayingcashwhen
thesaleismade.Mickster isplanning
tobuy150helmets inJanuaryand250Helmets inMarch.
ThesalestoMickster areinadditiontothosecreditsalesstatedabove.
Purchases (anaverage of30days’credit) are$4perhelmet. Benplanstobuyinthehelmets a
month inadvance ofsellingthem.Totaloverheadsare$2,000permonth; thisincludes$400
depreciationandwagesof$1,000.Allotheroverheads arepaidforaftera creditperiod of30
days.
Benplanstoinjecta further $5,000ofhisownmoney intothebusiness inMarchtohelptobuy
non-current assetsfor$29,000.Theseassetswillbedepreciatedoverfiveyears.
Opening cashflowisnegative $4,550whichisclosetoBen’soverdraft limitof$5,500.
Required
Prepare
a monthly
cashflowforecast
forthefirstquarter
of20X2andcomment
onyourresults.

Solution

G H

4:Cashmanagement
andworking
capital
finance 75

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 q

1.2.2 Workingcapitalmovements
Ifa questionprovides
youwithoperating cashflowsandworking capitalmovements,youmay
berequired toadjust
theoperating cashflowsforthecashflow impactofworkingcapital
movements tocalculate
monthly cashflows.
Takingthepreviousactivity,
ifyouhadbeengiventheoperating cashflowsinJanuaryasbeing
$17,270andhadbeentoldthat,during Januaryreceivablesareforecasttoincrease
by$10,000
(meaning that$10,000ofrevenue isdeferredtothenextperiod),
tradepayablesareforecast
to
increaseby$7,400(meaning that$7,400ofcostisdeferred tothenextperiod)andinventory
is
forecasttoriseby$7,400(incurring $7,400ofcostinthisperiod);
thenthenetcashflowin
G
Januarycouldbecalculated as: H

$
Original
operating
cashflows 17,270
Lessincrease
inreceivables (10,000)
Plusincrease
inpayables 7,400
Lessincrease
ininventory (7,400)
NetcashflowforJanuary 7,270

Essentialreading

SeeChapter 4 Section
1oftheEssential
Reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
practice
onthisarea.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.

1.3 Methods of easing cash shortages

Thestepsthatareusually
takenbya company whena needforcasharises,
andwhenitcannot
obtain
resourcesfromnewsourcesoffinance,couldinclude
thefollowing:
(a) Delaying
non-essential
capitalexpenditure
Somenewnon-currentassetsmightnotbeneeded forthedevelopmentandgrowthofthe
business,
butitmaynotbepossible todelaysomecapitalexpenditures
without
serious
consequences.

76 Financial
Management
(FM)

Page 98 of 641
 q
Forexample, ifa company’s policyistoreplace company carseverytwoyears,butthecompany
isfacinga cashshortage, itmightdecidetoreplace carseverythreeyears.
(b) Accelerating cashinflows whichwouldotherwise beexpected ina laterperiod.
Itmightbepossible toencourage creditcustomers topaymorequickly byofferingdiscounts
for
earlier
payment. Thiswascovered inChapter 3.
(c) Reversing pastinvestment decisions bysellingassetspreviously acquired
Someassetsarelesscrucialtoa business thanothers.Ifcashflowproblems aresevere,
theoption
ofselling
investments orpropertymighthavetobeconsidered. Saleandleaseback ofproperty
couldalsobeconsidered.
(d) Negotiating a reductionincashoutflows topostpone orreduce payments
Thereareseveral waysinwhichthiscouldbedone:
• Longer creditmightbetakenfromsuppliers. Suchanextension ofcreditwouldhavetobe
negotiatedcarefully:therewould bea riskofhaving furthersuppliesrefused.
• Loanrepayments couldberescheduled byagreement witha bank.
• Dividend payments couldbereduced. Dividendpayments arediscretionary
cashoutflows,
however cutting thedividendislikelytobeinterpreted assignofweakness bythefinancial
markets sothiscouldbeconsidered asa lastresort.
1.4 Managing cash surpluses
Ifcashsurpluses
areonlyforecastfortheshort-term
(egduetoseasonal factors)
andwillbe
required
tooffsetcashdeficits
inthenear-future,
thenitwillbeimportant
toinvest
thesecash
surpluses
ina waythatminimises risk(because
thefundswillbeneeded soon).
Desirable
investments
wouldgenerally belowriskandliquid(ieeasytoturnintocash).These
couldinclude:
Definition
G H

Treasury
bills Short-term
government
IOUs,canbesoldwhenneeded
Termdeposits Fixedperiod
deposits
Certificates
ofdeposit Issued
bybanks,
entitle
theholder
tointerest
plusprincipal,
canbe
soldwhenneeded
Commercial
paper Short-term
IOUsissued
bycompanies,
unsecured

Ifcashsurplusesareforecast
forthelong-term(egduetoseasonal
factors)
thena different
perspective
canbetaken. Long-term cashsurpluses
maybeusedtofund:
(a) Investments– newprojectsoracquisitions
(b) Financing– repaydebt,buybackshares
(c) Dividends– returning
fundstoshareholders
These areasarecoveredinlaterchapters.

Essentialreading

SeeChapter 4 Section
2 oftheEssential
reading,
available
inthedigitaledition
oftheWorkbook,
forfurther
discussion
ofthisarea.
TheEssential
readingisavailable
asanAppendix
ofthedigitaledition
oftheWorkbook.

2 Mathematical models
Anumber
ofdifferent
cashmanagement
models
indicate
theoptimum
amount
ofcashthata
company
shouldhold.

4:Cashmanagement
andworking
capital
finance 77

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 q
2.1 Baumol model
TheBaumol model isbasedontheideathatdecidingonoptimum cashbalancesislikedeciding
onoptimum inventorylevels.
Itassumesthatcashissteadily
consumedovertimeanda business
holdsa stockofmarketable
securities
thatcanbesoldwhencashisneeded. TheBaumol modelis
anadaptation oftheEOQmodel tomanage cash.

Formulaprovided

Economicorder quantity = 2CoD

Ch

Thecostofholdingcash(Ch)isthecostofobtaining
thefundsnetofanyinterest
earned
by
investing
thefunds.
Thecostofplacinganorder(Co)istheadministration
costincurred
whenselling
thesecurities.
Thedemand (D)istheannualcashrequired.
Illustration1:Baumolapproachto cash management

Finder
Cofacesa fixedcostof$400toobtain
newfunds.Itrequires
$240,000ofcasheachyear.
Theinterest
costonnewfinance is12%peryearandtheinterest
earnedonshort-term
securities
is
9%peryear.
Required
Howmuchfinance
should
Finder
raiseata time?

G
Solution H

Thecostofholdingcashis12%– 9%=3%
Thecostofplacinganorderis$400
Theannualdemand is$240,000
Applying
theEOQformula, theoptimum
levelofQ(the‘reorder
quantity’)
is:
2 × 400× 240,000= $80,000
0.03
Theoptimumamount ofnewfundstoraiseis$80,000.Thisamount
israised
threetimes
every
year(240,000÷80,000).

Activity2: Baumolmodel

Adivision
requires
$1.5m
peryear;cashuseisconstant
throughout
theyear.Transaction
costsare
$150pertransaction
anddeposit
interest
isgenerated
at7.5%andinterest
onshort-term
financial
securities
is12%.
Required
Whatistheoptimaleconomicquantity
ofcashtransfer
intothisdivision’s
sub-account
andhow
frequently?
 $1,500,000oncea year
 $77,500,
19times a year
 $61,200,25timesa year
 $100,000,15timesa year

78 Financial
Management
(FM)

Page 100 of 641

 q
2.1.1 DrawbacksoftheBaumolmodel
(a) Inreality,
itisdifficult
topredict
amounts required
overfuture
periods
withmuchaccuracy.
(b) Itisunlikelythatcashwillbeusedata constant
rateoveranygivenperiod
(there
willpoints
intimewhencashoutflowswillspikeasmachinery isboughtoraninterest
paymentona
loanismadeetc).
2.2 Miller-Orr model
Anothercashmanagement model istheMiller-Orrmodel,whichrecognises thatcashinflowsand
outflowsvaryconsiderablyona daytodaybasis.Thisisclearlymorerealistic thantheBaumol
model’sassumption ofconstant usageofcashduring a period.
Itworksasfollows:
(a) Asafetylevel(lowerlimit)ofcashisdecided upon(oftenthiswillbeimposed bya bank).
(b) Astatistical
calculation
iscompleted toestablish
theupperlimit(themaximum cashthatwill
berequired)takingintoaccount thevariability
ina firm’s
cashflows. Thedifference
between
thelowerandupperlimits iscalleda spread,thisiscalculated
usinga formula(whichis
given):
( Interest
rate )1
Spread = 3 3 × Transactioncost × Varianceofcashflows 3
4

Theupperlimit= lowerlimit+ spread

(c) Thecashbalance ismanaged toensure thatthebalance atanypointintimeiskeptbetween
thelower andupperlimits.
Ifthecashbalance reaches anupperlimit(point Ainthefollowing diagram) thefirmbuys
sufficient
securitiestoreturnthecashbalance toa normallevel(calledthe‘return
point’).
Whenthecashbalance reaches a lowerlimit(point
B),thefirmsellssecurities
tobringthe
balance backtothereturn point.
G
Cash A
H

balance Upper
limit

Thefirm
buyssecurities

Return
point
Thefirm
sells
securities
Lower
limit
B

0 Time

Formulaprovided

Thereturn
pointiscalculated
as:Lower
limit+ (1/3×spread)
Thisformula
isalsogiven.

Illustration2: Miller-Orr

Thefollowing
dataapplies
toa company.
(1) Theminimum
cashbalance is$8,000.

4:Cashmanagement
andworking
capital
finance 79

Page 101 of 641

 q
(2) Thevariance
ofdailycashflowsis$4,000,000,
equivalenttoa standard
deviation
of$2,000
perday(note:standarddeviation
isthesquare
rootofthevariance).
(3) Thetransaction
costforbuyingorselling
securities
is$50.Theinterest
rateis0.025%per
day.
Required
Youarerequired
toformulate
a decision
ruleusingtheMiller-Orr
model.

Solution
(1) Thespread between
theupperandlowercashbalance
limits
iscalculated
asfollows.
( )1
Spread = 3 3 × Transactioncost× Varianceofcashflows
3
4 Interest
rate
( )1
Spread = 3 3 × 50× 4,000,000
3
4 0.00025 =
3 × (6 × 10 11) 1 = 3 × 8,434.33 = $25,303 say $25,300
3
(2) Theupperlimitandreturn pointarenowcalculated.
Upperlimit= lower
limit+ $25,300=$8,000+$25,300=$33,300
Returnpoint= lowerlimit+ 1/3×spread= $8,000+1/3×$25,300
=$16,433,
say$16,400
(3) Thedecisionrulesareasfollows.
• Ifthecashbalance reaches $33,300,buy$16,900(=33,300- 16,400)
inmarketable
securities.
• Ifthecashbalance fallsto$8,000,sell$8,400ofmarketable
securities
forcash.
G H

Examfocus point
Variance=standarddeviation
2soifyouaregiventhestandarddeviation,
youwillneedto
squareittocalculate
thevariance.
Ifyouaregiventheannualinterest
rate,youwillneedtodivide
itby365toobtainthedaily
interest
rate.

2.2.1 DrawbacksoftheMiller-Orrmodel
Theusefulness
oftheMiller-Orrmodel islimited
bytheassumptions onwhichitisbased:
• Theestimatesused(forexample ofvariability)
arelikelytobebasedonhistoric information
whichmayunreliable asa predictoroffuture
variability
(forexample
iftheeconomic or
competitive
environmentchanges).
• Themodeldoesnotincorporate theimpact ofseasonality:forexample,
fora retailer,
seasonal
factors
arelikelytoaffectcashinflows.

3 Working capital finance

Asa business
grows,itsnon-current
assetandcurrent
assetbaseneedtogrowandthishas
implications
forfinancing.
Hereweconsider
different
strategies
forfinancing
working
capital.

Workingcapitalfinance:
Theapproach
takentofinancing
thelevel,andfluctuations
inthe
KEY
TERM level,
ofnetworking capital.

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Management
(FM)

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 q
Inordertounderstand workingcapitalfinancing
decisions,
assetswillbedividedintothree
different
types.
(a) Non-current(fixed)assets
Long-term assetsfromwhichanorganisationexpectstoderivebenefitovera number ofperiods;
forexample,buildingsormachinery.
(b) Permanent currentassets
Theminimum current
assetbase(eginventory,receivables)
required
tosustain normaltrading
activity.
(c) Fluctuatingcurrentassets
Thevariationincurrentassetsduring
a period,
forexampleduetoseasonal variations.
3.1 Working capital finance strategies
Therearedifferent
waysinwhichlong-andshort-termsourcesoffundingcanbeusedtofinance
current
andnon-current
assets.
Chapter9willexamine
specific
typesofshort-andlong-term
finance inmoredetail,herewe
discuss
someofthegeneralcharacteristics
ofshort-andlong-term finance.
3.1.1 Long-termfinanceandshort-termfinancecompared
Long-term financeisusually
moreexpensive thanshort-termfinance
becauseinvestors
require
a
higherreturnforlockingtheirmoneyawayforlongertimeperiods.
However,long-term financeprovides
highersecurity
totheborrower thanshort-term
finance,
because thereisnoguarantee thatshort-term
financewillbeavailable
tothemwhenitisneeded
inthefuture.
3.1.2 Aggressiveandconservative workingcapitalfinancingstrategies
Intheprevious
chapterweidentified
thatworking
capitalinvestment
strategies
canbe
G aggressive
(lownetworkingcapital)
orconservative
(highnetworkingcapital). H

Similar
terminology
exists
whenwediscuss working
capitalfinancing
strategies.
Aggressive
financingstrategy Conservative
financingstrategy
Minimallong-term
finance
forworking Highleveloflong-term
finance
forworking
capital capital
Mainlyusescheaper short-termsourcesof Mainlyusesmoresecure long-termsources
finance
– short-termfundsareusedto offinance– long-termfundsareusedto
finance
fluctuating
currentassetsanda financepermanent currentassetsanda
proportionofpermanentcurrent assets. proportion
offluctuating current
assets.
Leadstoproblemsifshort-termfinanceisnot Thisstrategyissaferbutcanbeexpensive
available
whenrequired.Thisstrategy
is
therefore
risky

Thefollowingdiagramrelates
thesetypesofstrategytotheinvestmentinnon-current
assetsand
currentassetsofa business.
Thecurved linerepresents
thefinancerequiredatanypointintime.
Thedotted linesA,BandC aredifferentpossible
levelsoflong-term
finance,
dependingonthe
workingcapitalfinance
strategybeingfollowed.
Assets
abovetherelevant dottedlinearefinancedbyshort-term funding
whileassetsbelowthe
dottedlinearefinancedbylong-term funding.

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andworking
capital
finance 81

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 q
Assets
($)
A
Fluctuating
current
assets
C
B
Permanent
current
assets

Non-current
assets

0 Time
­ Aisa conservative
(a) Policy working capitalfinance strategy.
Allnoncurrent assetsandpermanent current assets,aswellasa significant
partofthe
fluctuatingcurrentassets,arefinanced bylong-term funding.
Attimes whenfluctuatingcurrent assetsarelowandtotalassetsfallbelow lineA,therewillbe
surpluscashwhichthecompany willbeabletoinvest inmarketable securities.
(b) PolicyBisanaggressive working capitalfinancestrategy.
Allfluctuatingcurrentassetsallfinanced outofshort-term sources,andalsosomeofthe
permanent current
assets.Minimal long-term finance isused.
(c) PolicyC isa matching (ormoderate) approach.
Abalance between riskandreturn isachieved bypolicyC, a policyofmaturitymatching in
whichlong-term fundsfinance permanent assetswhileshort-term fundsfinancenon-permanent
assets.Thismeans thatthematurity ofthefundsmatches thematurity
oftheassets.
G H

Examfocus point
Becareful
nottoconfuseworkingcapitalinvestmentandworking capitalfinancing
strategies.
Theamountofworkingcapitalthata company choosestohaveisaninvestment
decision
whereasthetypeoffinancing
itusesforitsworking capitalisa financing
decision.
Inexamquestions,
manystudentsdonotdemonstrate knowledge oftheconservative,
aggressive
andmatchingapproachestoworking capitalfinancing.

3.2 Choice of working capital finance strategy

Theworking capitalfinancestrategythatismostappropriate toa company depends on
(a) Management attitudetorisk– short-term financeishigherrisktotheborrowerbecause it
maynotbeavailable inthefuturewhenneeded. Forexample,itmaynotbepossible to
accesstradecreditfromsuppliers whenitisrequired.
(b) Strength ofrelationshipwiththebankproviding anoverdraft– ifstrongthiswillencourage
theuseofshort-term financeasitmakes itmorelikelythata bankoverdraft willbeavailable
whenrequired toprovide short-termfinance.
(c) Abilitytoraiselong-term finance– ifthisisweak(perhaps because theorganisationissmall
and/or hasnotusedlong-term finance wisely inthepast)thiswillmeanthereisa greater
needtouseshort-term financebecause long-term financeishardtoaccess.

4 Treasury management
Theresponsibility
forarranging
short-andlong-term
finance
ispartoftheresponsibility
ofthe
Treasury
department.

82 Financial
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(FM)

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 q
4.1 Functions of treasury management
Treasury
management
normally
hasfourfunctions
Liquidity Risk
management management

Treasury
management

Funding Corporate
finance

4.1.1 Liquiditymanagement
Thisistheshort-term
management ofcashthatwehavereferredtoatthestartofthischapter.
Theaimistoensure thata companyhasaccesstothecashthatitneedsbutdoesnothold
unnecessarily
highlevels
ofcashanddoesnotincurhighcostsfromneedingtoorganise
unforeseenshort-term
borrowing.
4.1.2 Funding
Thisinvolves
deciding
onsuitable
formsoffinance
andorganising
suitable
bankandcapital
marketdebt.
Sourcesoffinancewillbecovered
inChapter9.
4.1.3 Corporatefinance
Thisistheexaminationofa company’s financial
strategies.
Forexample,
isthecapitalstructure
appropriate,
howareinvestments appraised,andhowarepotential
acquisitions
valued?
These areasareallcoveredinlaterchapters.
G H

4.1.4 Riskmanagement
Thisinvolves
understanding
andquantifying
therisksfacedbya company.
Inthisexamthemainfocusisoncurrency
riskandinterest
raterisk(covered
inChapters
14and
15).
4.2 Centralisation of treasury management
Withina centralised
treasury
department,
thetreasurydepartmentisnormally
basedatHead
Officeandactsasanin-house bankserving
theinterests
ofthegroup.
Thishasa number ofadvantagescomparedtothealternative
ofallowing
eachdivision
to
organisetheirown(decentralised)
treasury
operations:
Advantagesof centralisation
Economies
ofscale Borrowingrequired
fora number ofsubsidiaries
canbe
arranged
inbulk(meaning lower administration
costsand
possibly
a betterloanrate),alsocombined
cashsurpluses
canbeinvestedinbulk.
Improved
riskmanagement Foreign exchange riskmanagement islikelytobeimproved
because a central
treasury
department canmatchforeign
currency income earnedbyonesubsidiary withexpenditure
inthesamecurrency byanothersubsidiary.Inthisway,the
riskoflosses onadverseexchangeratemovements canbe
avoided withoutincurring
thetimeandexpense inmanaging
foreignexchange risk.

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Advantagesof centralisation
Reduced
borrowing Cashsurpluses
inoneareacanbeusedtomatchtothecash
needsinanother,
soanorganisation
avoids
havinga mixof
overdrafts
andcashsurpluses
indifferent
localised
bank
accounts.
Lower
cashbalances Thecentralised
pooloffundsrequired
forprecautionary
purposes
willbesmallerthanthesumofseparate
precautionary
balanceswhichwouldneedtobeheldunder
decentralised
treasuryarrangements.
Expertise Experts
canbeemployedwithknowledge
ofthelatest
developments
intreasury
management.

However,somecompanies prefer
todecentralise
treasurymanagementbecause:
(a) Sourcesoffinancecanbediversified
andcanmatchlocalassets.
(b) Greaterautonomy canbegiventosubsidiaries
anddivisions
becauseofthecloser
relationships
theywillhavewiththedecentralised
cashmanagementfunction.
(c) Adecentralised
treasuryfunction
maybemoreresponsivetotheneedsofindividual
operating
units.

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Chapter summary

Workingcapital finance

Cashmanagement Mathematical
models

Motives
forholding
cash Baumol
Transaction,
precautionary
andspeculation • Uses
EOQmodel
motives • Assumes
constant
useofcash
which
isunlikely

Cashflowforecasting Miller-Orr
• Neat
layout • Recognises
cash
variability
• Carewith
timings
andnon-cash
items • Establishes
upper
andlower
cashlimits

Easing
cashshortages
• Practical
steps
designed
nottodamagethe
business
long-term
• Where
possible
avoiddividend
cuts
orcuts
to
important
capital
expenditure

Managing cashsurpluses
• Short-term
investments
inlowrisk,
highly
liquid
assets
• Long-term
surplus
needstobeusedtocreate
G
shareholder
value
orreturned
toshareholders H

Working
capitalfinance Treasury
management

Assettypes Functions
• Non-current
assets • Liquidity
management
• Permanent
current
assets • Funding
• Fluctuating
current
assets • Risk
management
• Corporate
finance
advice
Aggressive
financing
strategy
• Mainly
usesshort-term
finance
forcurrent Centralised
assets
andeven forsomepermanent
current • Economies
ofscale
assets • Improved
risk
management
• Cheaper
butrisky • Reduced
borrowing
• Lower
cashbalances
• Expertise
Conservative
financing
strategy
• Mainly
useslong-term
finance
fornon-current
assets,
permanent
current
assets
andalso Decentralised
somefluctuating
current
assets • Local
finance
used
• Safer,
butmoreexpensive • Autonomy
forsubsidiaries
• More
responsive

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Knowledge diagnostic

1.Cashflowforecasting
Thisisthekeytoolforcashmanagement.
Becareful
withcashflowtimings
andnon-cash
items.
2. Cashsurpluses
andshortages
Cashshortages
canbeeasedbypostponingcapitalexpenditure,
sellingassets,takinglonger
to
payaccounts
payableandpressingaccounts
receivable
forearlier
payment.
Temporary
cashsurpluses
canbeinvested
ina variety
oflowriskandhighlyliquidfinancial
instruments.
Longer-term
surpluses
should
bereturnedtoshareholders ifthereisa lackof
investment
opportunities.
3. Mathematical
models
Optimalcashholding
levels
canbecalculated
fromformal
models,
suchastheBaumol
model
and
theMiller-Orr
model.
4. Workingcapitalfinancestrategies
Aggressive
strategyrelies
mainly
onshort-termfinance
tofinanceworking
capital,a conservative
strategy
relies
moreonlong-term finance
tofinanceworkingcapital.
5. Treasury
management
Alargeorganisation
willhavea treasury
department tomanage liquidity,
funding,
risk
managementandcorporate financeadvice.
Thisisoftencentralised.

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Further study guidance

Question practice
Nowtrythefollowing
fromtheFurther
question
practice
bank(available
inthedigitaledition
of
theWorkbook):
Section
A questions
Q14
Section
C questions
Q42Velm

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Activity answers

Activity1:Cashforecast
Cashflowforecast
Jan Feb Mar
Inflows $ $ $
Sales
– Mickster
(Cash)
(98%×$10×150; 2,695
98%×$11×250) 1,470
Salesreceipts
(W1) 25,000
20,000 30,000
Capital
– – 5,000
Totalinflows 21,470 25,000 37,695

Outflows $ $ $
Purchases
(W2) 12,600 20,000 19,000
Overheads
(2,000– 400– 1,000) 600 600 600
G Wages 1,000 1,000 1,000 H

Non-current
assets – – 29,000
Totaloutflows 14,200 21,600 49,600

Netcashflow 7,270 3,400 (11,905)

Balance
b/f (4,550) 2,720 6,120
Balance
c/f 2,720 6,120 (5,785)

Working
Jan Feb Mar
Salesreceipts
from
2 monthsago
November
credit
sales 2,000×$10=20,000
December
credit
sales 2,500×$10=25,000
Januarycredit
sales 3,000×$10=30,000

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Jan Feb Mar
Supplier
invoices
from1month
ago
Decpurchases
for
Jan sales
(credit
&cash) 3,150×$4=12,600
Jan purchasesfor
Febsales(credit
only) 5,000×$4=20,000
Febpurchases
for
Marchsales
(credit
&cash) 4,750×$4=19,000

Activity2: Baumolmodel
Thecorrect answeris:$100,000,
15times
a year
Thecalculationisasfollows:
EOQ = 2 × 150× 1,500,000 = $100,000
0.045
ie15transfers
of$100,000
areneeded.

G H

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