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Chapter 10 Cash and Funding Strategies

SYLLABUS

1. Explain the various reasons for holding cash, and discuss and apply the use of
relevant techniques in managing cash, including:
(a) preparing cash flow forecasts to determine future cash flows and cash balances
(b) assessing the benefits of centralized treasury management and cash control
(c) cash management models, such as the Baumol model and Miller-Orr model
(d) investing short-term
2. Describe and discuss the key factors in determining working capital funding
strategies, including:
(a) the distinction between permanent and fluctuating current assets
(b) the relative cost and risk of short-term and long-term finance
(c) the matching principle
(d) the relative costs and benefits of aggressive, conservative and matching funding
policies
(e) management attitudes to risk, previous funding decisions and organization size

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Chapter Summary

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1. Reasons for Holding Cash

(Dec 12)
1.1 Although cash needs to be invested to earn returns, businesses need to keep a certain
amount readily available.

1.2 Motives of Holding Cash

(a) Transaction motive – cash required to meet day-to-day expenses, e.g.

payroll, payment of suppliers, etc.
(b) Finance motive – cash required to cover major items such as the
repayment of loans and the purchase of non-current assets.
(c) Precautionary motive – cash held to give a cushion against unplanned
expenditure (the cash equivalent of buffer inventory).
(d) Speculative motive – cash kept available to take advantage of market
investment opportunities.

1.3 Failure to carry sufficient cash levels can lead to:

(a) loss of settlement discounts
(b) loss of supplier goodwill
(c) poor industrial relations
(d) potential liquidation.
1.4 Once again therefore the firm faces a balancing act:

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Multiple Choice Questions

1. Although cash needs to be invested to earn returns, businesses need to keep a certain
amount readily available.

Which of the following is not a reason for holding cash?

A Movement motive
B Transactions motive
C Precautionary motive
D Investment motive

2. Cash Budgets and Cash Flow Forecasts

2.1 The usefulness of cash flow forecasts

2.1.1 A cash forecast is an estimate of cash receipts and payments for a future period under
existing conditions.
2.1.2 A cash budget is a commitment to a plan for cash receipts and payments for a future
period after taking any action necessary to bring the forecast into line with the overall
business plan.
2.1.3 The cash flow forecast is one of the most important planning tools that an organization
can use. It shows the cash effect of all plans made within the flow forecastary process
and hence its operation can lead to a modification of flow forecasts if it shows that
there are insufficient cash resources to finance the planned operations.
2.1.4 It can also give management an indication of potential problems that could arise
and allows them the opportunity to take action to avoid such problems.
2.1.5 A cash flow forecast can show four positions. Management will need to take
appropriate action depending on the potential position.

Cash Position Appropriate Management Action

Short-term surplus  Pay accounts payable early to obtain discount
 Attempt to increase sales by increasing accounts
receivable and inventories
 Make short-term investments
Short-term deficit  Increase accounts payable
 Reduce accounts receivable

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 Arrange an overdraft
Long-term surplus  Make long-term investments
 Expand
 Diversify
 Replace/update non-current assets
Long-term deficit  Raise long-term finance (such as via issue of share
capital)
 Consider shutdown/disinvestment opportunities

2.2 Preparing cash flow forecast

2.2.1 Forecasts can be prepared from any of the following:

(a) planned receipts and payments
(b) statement of financial position predictions
(c) working capital ratios.

(a) Preparing a cash flow forecast from planned receipts and payments
(Jun 09, Dec 14)
2.2.2 Every type of cash inflow and receipt, along with their timings, must be forecast. Note
that cash receipts and payments differ from sales and cost of sales in the income
statement because:
(a) not all cash items affect the income statement
(b) some income statement items are not cash flows
(c) actual timing of cash flows may not correspond with the accounting period in
which they are recorded.
2.2.3 Proforma of cash budget

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2.2.4 Example 1
You are presented with the following forecasted cash flow data for your
organization for the period November 2010 to June 2011. It has been extracted
from functional flow forecasts that have already been prepared.

Nov 10 Dec 10 Jan 11 Feb 11 Mar 11 Apr 11 May 11 Jun 11

$ $ $ $ $ $ $ $

Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000

Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000

Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000

Overheads 10,000 10,000 15,000 15,000 15,000 20,000 20,000 20,000

Dividends 20,000 40,000

Capital expenditure 30,000 40,000

You are also told the following.

(a) Sales are 40% cash 60% credit. Credit sales are paid two months after the
month of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.

The managing director is pleased with the above figures as they show sales will

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have increased by more than 100% in the period under review. In order to achieve
this he has arranged a bank overdraft with a ceiling of $50,000 to accommodate the
increased inventory sales and wage bill for overtime worked.

Required:

(a) Prepare a cash flow forecast for the six-month January to June 2011.
(b) Comment on your results in the light of the managing director’s comments
and offer advice.

Solution:

(a)
Jan Feb Mar Apr May Jun
Cash receipts $ $ $ $ $ $
Cash sales 44,000 52,000 56,000 60,000 64,000 72,000
Credit sales 48,000 60,000 66,000 78,000 84,000 90,000
92,000 112,000 122,000 138,000 148,000 162,000
Cash payments
Purchases 60,000 80,000 90,000 110,000 130,000 140,000
Wages: 75% 12,000 15,000 18,000 21,000 24,000 27,000
Wages: 25% 3,000 4,000 5,000 6,000 7,000 8,000
Overheads 10,000 15,000 15,000 15,000 20,000 20,000
Dividends 20,000
Capital expenditure 30,000 40,000
85,000 114,000 178,000 152,000 181,000 235,000

Net cash flow 7,000 (2,000) (56,000) (14,000) (33,000) (73,000)

Bal. b/f 15,000 22,000 20,000 (36,000) (50,000) (83,000)
Net 22,000 20,000 (36,000) (50,000) (83,000) (156,000)

(b)
The overdraft arrangements are quite inadequate to service the cash needs of the
business over the six-month period. If the figures are realistic then action should be
taken now to avoid difficulties in the near future. The following are possible
courses of action.
(i) Activities could be curtailed.

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(ii) Other sources of cash could be explored, for example a long-term loan to
finance the capital expenditure and a factoring arrangement to provide cash
due from accounts receivable more quickly.
(iii) Efforts to increase the speed of debt collection could be made.
(iv) Payments to accounts payable could be delayed.
(v) The dividend payments could be postponed (the figures indicate that this is a
small company, possibly owner-managed).
(vi) Staff might be persuaded to work at a lower rate in return for, say, an annual
bonus or a profit-sharing agreement.
(vii) Extra staff might be taken on to reduce the amount of overtime paid.
(viii) The stock holding policy should be reviewed; it may be possible to meet
demand from current production and minimize cash tied up in inventories.

Question 1 – Cash Budgets, overdraft and Baumol Model

Thorne Co values, advertises and sells residential property on behalf of its customers. The
company has been in business for only a short time and is preparing a cash budget for the
first four months of 2006. Expected sales of residential properties are as follows.
2005 2006 2006 2006 2006
Month December January February March April
Units sold 10 10 15 25 30

The average price of each property is £180,000 and Thorne Co charges a fee of 3% of the
value of each property sold. Thorne Co receives 1% in the month of sale and the remaining
2% in the month after sale. The company has nine employees who are paid on a monthly
basis. The average salary per employee is £35,000 per year. If more than 20 properties are
sold in a given month, each employee is paid in that month a bonus of £140 for each
additional property sold.

Variable expenses are incurred at the rate of 0·5% of the value of each property sold and
these expenses are paid in the month of sale. Fixed overheads of £4,300 per month are paid
in the month in which they arise. Thorne Co pays interest every three months on a loan of
£200,000 at a rate of 6% per year. The last interest payment in each year is paid in
December.

An outstanding tax liability of £95,800 is due to be paid in April. In the same month Thorne
Co intends to dispose of surplus vehicles, with a net book value of £15,000, for £20,000.
The cash balance at the start of January 2006 is expected to be a deficit of £40,000.

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Required:
(a) Prepare a monthly cash budget for the period from January to April 2006. Your budget
must clearly indicate each item of income and expenditure, and the opening and
closing monthly cash balances. (10 marks)
(b) Discuss the factors to be considered by Thorne Co when planning ways to invest any
cash surplus forecast by its cash budgets. (5 marks)
(c) Discuss the advantages and disadvantages to Thorne Co of using overdraft finance to
fund any cash shortages forecast by its cash budgets. (5 marks)
(d) Explain how the Baumol model can be employed to reduce the costs of cash
management and discuss whether the Baumol cash management model may be of
assistance to Thorne Co for this purpose. (5 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2005 Q5)

(b) Preparing a cash flow forecast from a statement of financial position

(Dec 09)
2.2.5 Used to predict the cash balance at the end of a given period, this method will
typically require forecasts of:
(a) changes to non-current assets (acquisitions and disposals)
(b) future inventory levels
(c) future receivable levels
(d) future payables levels
(e) changes to share capital and other long-term funding (e.g. bank loans)

2.2.6 Example 2
ABC Co has the following statement of financial position at 30 June 2014:
$ $
Non-current assets
Plant and machinery 192,000
Current assets
Inventory 16,000
Receivables 80,000
Bank 2,000
98,000
Total assets 290,000

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Equity and liabilities

Issued share capital 216,000
Retained profits 34,000
250,000
Current liabilities
Trade payables 10,000
Dividend payable 30,000
40,000
Total equity and liabilities 290,000

(a) The company expects to acquire further plant and machinery costing $8,000
during the year to 30 June 2015.
(b) The levels of inventories and receivables are expected to be increase by 5%
and 10% respectively by 30 June 2015, due to business growth.
(c) Trade payables and dividend liabilities are expected to be the same at 30 June
2015.
(d) No share issue is planned, and net profits for the year to 30 June 2015 are
expected to be $42,000.
(e) Plant and machinery is depreciated on a reducing balance basis, at the rate of
20% pa, for all assets held at the statement of financial position date.

Required:

Produce a balance sheet forecast as at 30 June 2015, and predict what the cash
balance or bank overdraft will be at that date.

Solution:
Statement of financial position at 30 June 2015
$ $
Non-current assets
Plant and machinery [(192,000 + 8,000) × 80%] 160,000
Current assets
Inventory (16,000 × 105%) 16,800
Receivables (80,000 × 110%) 88,000
Bank (balancing figure) 67,200
172,000
Total assets 332,000

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Equity and liabilities

Issued share capital 216,000
Retained profits (34,000 + 42,000) 76,000
292,000
Current liabilities
Trade payables 10,000
Dividend payable 30,000
40,000
Total equity and liabilities 332,000

The forecast is that the bank balance will increase by $65,200 (i.e. $67,200 –
$2,000). This can be reconciled as follows:
$ $
Retained profit 42,000
Add: Depreciation [20% of $(192,000 + 8,000)] 40,000
82,000
Less: non-current asset acquired (8,000)
74,000
Increase in inventory 800
Increase in receivables 8,000
(8,800)
Increase in cash balance 65,200

(c) Preparing a cash flow forecast from working capital ratios

2.2.7 Working capital ratios can also be used to forecast future cash requirements. The first
stage is to use the ratios to work out the working capital requirement, as we have
already seen in Chapter 8.

2.2.8 Example 3

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X Co had the following results for last year.

Income statement $m
Sales 200
Cost of sales (including $20m depreciation) 120
Operating profit 80
Interest 5
Profit before tax 75
Tax 22
Profit after tax 53
Dividend proposed 10
Retained earnings 43

Statement of financial position $m

Non-current assets 400
Current assets
Inventory 25
Receivables 33
Cash 40
98
Current liabilities
Trade payables 20
Dividend payable 10
Tax payable 22
52
Long term loan @ 10% 50

X Co expects the following for the forthcoming year.

Sales will increase by 10%
Plant and machinery will be purchased costing $12m
Inventory days 80 days
Receivable days 75 days

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Trade payables days 50 days

Depreciation will be $15m

Required:

Prepare a cash flow projection for the forthcoming period.

Solution:

Here we will assume that the gross profit percentage will remain unaltered in cash
terms.

$m
Last year
Sales 200
Cost of sales less depreciation 100
Operating cash flow 100
Gross profit percentage 50%

This year $m
Sales $200m × 110% 220
Cost of sales $220m × 50% 110
Operating cash flow 110

Next we calculate the working capital requirements (to the nearest $m)
$m
Inventory (80/365 × $110m) 24
Receivables (75/365 × $220m) 45
Trade payables (50/365 × $110m) 15

Now we assemble the information in the pro forma given earlier.

Note $m
1 Operating cash flow 110
2 Interest (5)
3 Tax (22)
3 Dividend (10)
4 Purchase of plant and machinery (12)

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5 Reduction in inventory ($24m – $25m) 1

5 Increase in receivables ($45m – $33m) (12)
5 Reduction in trade payables ($15m – $20m) (5)
Net cash flow 45

Notes
(1) We have already calculated operating cash flow so do not need to adjust for
depreciation of $15m.
(2) It is assumed that this is the same as last period, as the loans have not
changed.
(3) The tax and dividend payables in last year’s statement of financial position
will be paid in the forthcoming period.
(4) This was given in the question.
(5) Increase in current assets are an outflow, reductions are an inflow. The
reverse is the case for trade payables.

Question 2 – Overdraft and Cash Flows Forecast

CPA is a manufacturing company in the furniture trade. Its sales have risen sharply over the
past six months as a result of an improvement in the economy and a strong housing market.
The company is now showing signs of ‘overtrading’ and the financial manager, Ms Smith, is
concerned about its liquidity. The company is one month from its year end. Estimated
figures for the full 12 months of the current year and forecasts for next year, on present cash
management policies, are shown below.

Next year Current year

Income statement $000 $000
Revenues 5,200 4,200
Less: Cost of sales (Note 1) 3,224 2,520
Operating expenses 650 500
Operating profit 1,326 1,180
Interest paid 54 48
Profit before tax 1,272 1,132
Tax payable 305 283
Profit after tax 967 849

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Dividends declared 387 339

Current assets and liabilities as at the end of the

year
Inventory/work-in-progress 625 350
Receivables 750 520
Cash 0 25
Trade payables 464 320
Other payables (tax and dividends) 692 622
Overdraft 11 0
Net current assets/(liabilities) 208 (47)

Note 1: Cost of sales includes depreciation of 225 175

Ms Smith is considering methods of improving the cash position. A number of actions are
being discussed.

Debtors
Offer a 2% discount to customers who pay within 10 days of despatch of invoices. It is
estimated 50% of customers will take advantage of the new discount scheme. The other 50%
will continue to take the current average credit period.

Trade payables and inventory

Reduce the number of suppliers currently being used and negotiate better terms with those
that remain by introducing a just-in-time policy. The aim will be to reduce the end-of-year
forecast cost of sales (excluding depreciation) by 5% and inventory/WIP by 10%. However,
the number of days credit taken by the company will have to fall to 30 days to help persuade
suppliers to improve their prices.

Other information
 All trade is on credit. Official terms of sale at present require payment within 30 days.
Interest is not charged on late payments.
 All purchases are made on credit.
 Operating expenses will be $650,000 with the existing or proposed policies.
 Interest payments would be $45,000 if the new policies are implemented.

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 Capital expenditure of $550,000 is planned for next year.

Required:

(a) Explain the main uses of overdraft facilities as part of a company’s working capital
management policy. (5 marks)
(b) Prepare a cash flow forecast for next year, assuming:
(i) The company does not change its policies
(ii) The company’s proposals for managing customers, suppliers and inventory are
implemented
In both cases, assume a full twelve-month period, that is the changes will be effective
from day 1 of next year. (14 marks)
(c) As assistance to Ms Smith, write a short report to her discussing the proposed actions.
Include comments on the factors, financial and non-financial, that the company should
take into account before implementing the new policies. (6 marks)
(Total 25 marks)

Multiple Choice Questions

2. Which of the following should NOT be included in a cash flow forecast?

A Funds from the issue of share capital

B Repayment of a bank loan
C Receipts of dividends from outside the business
D Revaluation of a noncurrent asset

3. Roger plc's projected revenue for 20X4 is $350,000. It is forecast that 12% of sales
will occur in January and remaining sales will be equally spread among the other
eleven months. All sales are on credit. Receivables accounts are settled 50% in the
month of sale, 45% in the following month, and 5% are written off as bad debts after
two months.

Which of the following amounts represents the budgeted cash collections for March?

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A $24,500
B $26,600
C $28,000
D $32,900

4. JP Co has budgeted that sales will be $300,100 in January 20X2, $501,500 in

February, $150,000 in March and $320,500 in April. Half of sales will be credit sales.
80% of receivables are expected to pay in the month after sale, 15% in the second
month after sale, while the remaining 5% are expected to be bad debts. Receivables
who pay in the month after sale can claim a 4% early settlement discount.

What level of sales receipts should be shown in the cash budget for March 20X2 (to
the nearest $)?

A 290,084
B 298,108
C 580,168
D 596,216

5. ABC Co’s cash budget highlights a short-term surplus in the near future.

Which of the following actions would be appropriate to make use of the surplus?

A Pay suppliers earlier to take advantage of any prompt payment discounts

B Buy back the company’s shares
C Increase payables by delaying payment to suppliers
D Invest in a long term deposit bank account

6. Which of the following actions would be appropriate if the cash budget identified a
short term cash deficit?

A Issue shares
B Pay suppliers early
C Arrange an overdraft
D Invest in a short term deposit account

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3. Treasury Management (資金管理)

3.1 Functions of treasury management

3.1.1 Functions of treasury management

Treasury management is concerned with liquidity and covers the following
activities:
(a) banking and exchange
(b) cash and currency management
(c) investment in short-term assets
(d) risk and insurance
(e) raising finance.

3.1.2 Originally the activities were carried out within the general finance function, but today
are often separated into a treasury department, particularly in large international
companies. Reasons for the change include:
(a) increase in size and global coverage of the companies
(b) increasingly international markets
(c) increase in sophistication of business practices.

3.2 Treasury responsibility

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3.2.1 The treasurer will generally report to the finance director (financial manager), with a
specific emphasis on borrowing and cash and currency management. The
treasurer will have a direct input into the finance director’s management of debt
capacity, debt and equity structure, resource allocation, equity strategy and
currency strategy.
3.2.2 The treasurer will be involved in investment appraisal, and the finance director will
often consult the treasurer in matters relating to the review of acquisitions and
divestments, dividend policy and defence from takeover.
3.2.3 Treasury departments are not large, since they are not involved in the detailed
recording of transactions.

3.3 Centralisation of the treasury department

3.3.1 The following are advantages of having a specialist centralized treasury department.
(a) Centralised liquidity management
(i) Avoid having mix of cash surpluses and overdrafts in different localized
bank accounts.
(ii) Facilitates bulk cash flows, so that lower bank charges can be
negotiated.
(b) Larger volumes of cash are available to invest, giving better short-term
investment opportunities (for example money markets, high-interest accounts
and CDs).
(c) Any borrowing can be arranged in bulk, at lower interest rates than for
smaller borrowings, and perhaps on the eurocurrency or eurobond markets.
(d) Foreign exchange risk management is likely to be improved in a group of
companies. A central treasury department can match foreign currency income
earned by one subsidiary with expenditure in the same currency by another
subsidiary. In this way, the risk of losses on adverse exchange rate movements
can be avoided without the expense of forward exchange contracts or other
hedging methods.
(e) A specialist treasury department can employ experts with knowledge of
dealing in forward contracts, futures, options Eurocurrency markets, swaps,
and so on. Localised departments could not have such expertise.
(f) The centralized pool of funds required for precautionary purposes will be
smaller than the sum of separate precautionary balances which would need
to be held under decentralized treasury arrangements.
(g) Through having a separate profit centre, attention will be focused on the

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contribution to group profit performance that can be achieved by good cash,

funding, investment and foreign currency management.

3.3.2 Possible advantages of decentralized cash management are as follows.

(a) Sources of finance can be diversified and can match local assets.
(b) Greater autonomy can be given to subsidiaries and divisions because of the
closer relationships they will have with the decentralized cash management
function.
(c) A decentralized treasury function may be more responsive to the needs of
individual operating units.

Multiple Choice Questions

7. Which of the following is NOT a common role of the treasury function within a firm?

A Short-term management of resources

B Long-term maximization of shareholder wealth
C Long-term maximization of market share
D Risk management

8. Which of the following is a disadvantage of having a centralized treasury department

in a large international group of companies?

A No need for treasury skills to be duplicated throughout the group

B Necessary borrowings can be arranged in bulk, at keener interest rates than for
smaller amounts.
C The group’s foreign currency risk can be managed much more effectively since
they can appreciate the total exposure situation.
D Local operating units should have a better feel for local conditions than head
office and can respond more quickly to local developments.

Question 3
Briefly describe the main functions of a treasury department. (4 marks)

4. Cash Management Models

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4.1 Introduction

4.1.1 Cash management models are aimed at minimizing the total costs associated with
movements between:
(a) a current account (very liquid but not earning interest) and
(b) short-term investments (less liquid but earning interest).
4.1.2 The models are devised to answer the questions:
(a) at what point should funds be moved?
(b) how much should be moved in one go?

4.2 The Baumol cash management model

4.2.1 Baumol Cash Management Model

(a) Baumol noted that cash balances are very similar to inventory levels, and
developed a model based on the economic order quantity (EOQ).
(b) Assumptions:
(i) cash use is steady and predictable
(ii) cash inflows are known and regular
(iii) day-to-day cash needs are funded from current account
(iv) buffer cash is held in short-term investments.
(c) The formula calculates the amount of funds to inject into the current account
or to transfer into short-term investments at one time:

C0 = transaction costs (brokerage, commission, etc.)

D = demand for cash over the period
CH = cost of holding cash, i.e. the interest difference between the rate paid on
short-term investments and the rate paid on a current account

4.2.2 Example 4
A company generates $10,000 per month excess cash, which it intends to invest in
short-term securities. The interest rate it can expect to earn on its investment is 5%
pa. The transaction costs associated with each separate investment of funds is
constant at $50.

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Required:

(a) What is the optimum amount of cash to be raised (or invested) in each
transaction?
(b) How many transactions will arise each year?
(c) What is the cost of making those transaction pa?
(d) What is the opportunity cost of holding cash pa?

Solution:

(a)

(b) Number of transactions pa =

(c) Annual transaction cost = 7.75 x $50 = $387

(d) Annual opportunity cost (holding cost) =

4.2.3 Drawbacks of the Baumol model

(a) In reality, it is unlikely to be possible to predict amounts required over
future periods with much certainty.
(b) No buffer inventory of cash is allowed for. There may be costs associated
with running out of cash.
(c) There may be other normal costs of holding cash which increase with the
average amount held.

4.3 The Miller-Orr cash management model

(Pilot, Jun 12)

4.3.1 Miller-Orr Cash Management Model

(a) The Miller-Orr model controls irregular movements of cash by the setting
of upper and lower control limits on cash balance.
(b) The Miller-Orr model is used for setting the target cash balance.

4.3.2 The diagram below shows how the model works over time.
(a) The model sets higher and lower control limits, H and L, respectively, and a

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target cash balance, Z.

(b) When the cash balance reaches H, then (H – Z) dollars are transferred from
cash to marketable securities, i.e. the firm buys (H – Z) dollars of securities.
(c) Similarly when the cash balance hits L, then (Z – L) dollars are transferred
from marketable securities to cash.

4.3.3 The lower limit, L is set by management depending upon how much risk of a cash
shortfall the firm is willing to accept, and this, in turn, depends both on access to
borrowings and on the consequences of a cash shortfall.
4.3.4 If the cash balance reaches the lower limit it must be replenished in some way, e.g. by
the sale of marketable securities or withdrawal from a deposit account. The size of this
withdrawal is the amount required to take the balance back to the return point. It is the
distance between the return point (usually set in Miller-Orr as the lower limit plus one
third of the distance up to the upper limit) and the lower limit.
4.3.5 If the cash balance reaches the upper limit, an amount must be invested in marketable
securities or placed in a deposit account, sufficient to reduce the balance back to the
return point. Again, this is calculated by the model as the distance between the upper
limit and the return point.
4.3.6 The minimum cost upper limit is calculated by reference to brokerage costs, holding
costs and the variance of cash flows. The model has some fairly restrictive
assumptions, e.g. normally distributed cash flows but, in tests, Miller and Orr found it
to be fairly robust and claim significant potential cost savings for companies.

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4.3.7 The Formula for the Miller-Orr Model

(a) Return point = Lower limit + (1/3 × spread)

(b) Spread =

Variance and interest rates should be expressed in daily terms.

4.3.8 Example 5
The minimum cash balance of $20,000 is required at ABC Co, and transferring
money to or from the bank costs $50 per transaction. Inspection of daily cash flows
over the past year suggests that the standard deviation is $3,000 per day, and hence
the variance (standard deviation squared) is $9 million. The interest rate is 0.03%
per day.

Calculate:
(a) the spread between the upper and lower limits
(b) the upper limit
(c) the return point

Solution:

(a) Spread = 3 × (3/4 × 50 × 9,000,000/0.0003)1/3 = $31,200

(b) Upper limit = 20,000 + 31,200 = $51,200
(c) Return point = 20,000 + 31,200/3 = $30,400

Multiple Choice Questions

9. Assumption 1: Amounts of cash required in future periods can be predicted with

certainty.
Assumption 2: The opportunity cost of holding cash is known and it does not change
over a period of time.

Which of the above, if either, is an assumption on which Baumol’s model of cash

management is based?

A Both Assumption 1 and Assumption 2

B Assumption 1 only
C Assumption 2 only

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D Neither Assumption 1 nor Assumption 2

10. WW Co is a subsidiary of BB Co. WW Co requires $10 million in finance to be easily

spread over the coming year, which BB Ltd will supply. Research shows:

There is a standing bank fee of $200 for each drawdown.

The interest cost of holding cash (ie finance cost less deposit interest) is 6% pa.

How much should WW Co draw down at a time (to the nearest $'000)?

A $8,000
B $67,000
C $258,000
D $26,000

11. A company needs $150,000 each year for regular payments. Converting the company’s
short-term investments into cash to meet these regular payments incurs a fixed cost of
$400 per transaction. These short-term investments pay interest of 5% per year, while
the company earns interest of only 1% per year on cash deposits.

According to the Baumol Model, what is the optimum amount of short-term

investments to convert into cash in each transaction?

A $38,730
B $48,990
C $54,772
D $63,246
(ACCA F9 Financial Management June 2015)

12. The treasury department in TB Co has calculated, using the Miller-Orr model, that the
lowest cash balance they should have is $1m, and the highest is $10m. If the cash
balance goes above $10m they transfer the cash into money market securities.

Which of the following is/are true?

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1 When the balance reaches $10m they would buy $6m of securities
2 When the cash balance falls to $1m they will sell $3m of securities
3 If the variance of daily cash flows increases the spread between upper and lower
limit will be increased.

A 1 and 2 only
B 3 only
C 2 and 3 only
D 1, 2 and 3

Question 4 – Changes of credit policy, Miller-Orr Model, AR management and

working capital funding policy
Ulnad Co has annual sales revenue of $6 million and all sales are on 30 days’ credit,
although customers on average take ten days more than this to pay. Contribution represents
60% of sales and the company currently has no bad debts. Accounts receivable are financed
by an overdraft at an annual interest rate of 7%.

Ulnad Co plans to offer an early settlement discount of 1.5% for payment within 15 days
and to extend the maximum credit offered to 60 days. The company expects that these
changes will increase annual credit sales by 5%, while also leading to additional incremental
costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers,
with the remaining customers taking an average of 60 days to pay.

Required:

(a) Evaluate whether the proposed changes in credit policy will increase the profitability
of Ulnad Co. (6 marks)
(b) Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of
$7,500. The average cost to the company of making deposits or selling investments is
$18 per transaction and the standard deviation of its cash flows was $1,000 per day
during the last year. The average interest rate on investments is 5.11%. Determine the
spread, the upper limit and the return point for the cash account of Renpec Co using
the Miller-Orr model and explain the relevance of these values for the cash
management of the company. (6 marks)
(c) Identify and explain the key areas of accounts receivable management. (6 marks)
(d) Discuss the key factors to be considered when formulating a working capital funding

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policy. (7 marks)
(Total 25 marks)
(ACCA F9 Financial Management Pilot Paper Q3)

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5. Short-term Investment and Borrowing Solutions

5.1 Introduction

5.1.1 The cash management models discussed above assumed that funds could be readily
obtained when required either by liquidating short-term investments or by taking out
short-term borrowing.
5.1.2 A company must choose from a range of options to select the most appropriate
source of investment/funding.

5.2 Short-term cash investments

5.2.1 Short-term cash investments are used for temporary cash surpluses. To select an
investment, a company has to weigh up three potentially conflicting objectives and the
factors surrounding them.

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5.2.2 Objectives in the investment of surplus cash (Dec 14)

(a) Liquidity – the cash must be available for use when needed.
(b) Safety – no risk of loss must be taken.
(c) Profitability – subject to the above, the aim is to earn the highest possible
after-tax returns.
5.2.3 The following factors should be considered in the investment of surplus cash, it
should be noted that the above objectives should also be considered.
(d) Length of time the surplus is available for.
(e) The size of the surplus – some instruments may have minimum investment
levels.
(f) The risk associated with each instrument, and
(g) Any penalties for early withdrawal.

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5.3 Short-term investment

5.3.1 Temporary cash surpluses are likely to be:

(a) Deposited with a bank or similar financial institution.
(b) Invested in short-term debt instruments (Debt instruments are debt securities
which can be traded, e.g. certificates of deposit (CDs) and Treasury bills).
(c) Invested in longer term debt instruments, which can be sold on the stock
market when the company eventually needs the cash.
(d) Invested in shares of listed companies, which can be sold on the stock market
when the company eventually needs the cash.
5.3.2 A certificate of deposit (CD) is a security that is issued by a bank, acknowledging
that a certain amount of money has been deposited with it for a certain period of time
(usually, a short term). The CD is issued to the depositor, and attracts a stated amount
of interest. The depositor will be another bank or a large commercial organization.
5.3.3 Treasury bills (短期國債) are issued weekly by the government to finance short-term
cash deficiencies in the government’s expenditure program. Treasury bills have a term
of 91 days to maturity, after which the holder is paid the full value of the bill.
(美國政府發行的債務證券，期限少於或等於一年。短期國庫券通過競標過程發
售，價格相對面值有折扣，所以不會像大部分其他債券一般支付定額利息。此種
證券是由財政部按拍賣方式折價出售，面值和發行價格的差價是投資的報酬。其
可分為四種：三個月，六個月，九個月及一年，但以三個月占絕大部分。國庫券
具有無信用風險，高度流動性及易於轉讓，容易兌現現金，轉讓手續費低等特質
T-bill 面額不像其他金融工具一樣面值至少要達到 100,000， 它可以是$1,000,
$5,000, $100,000, 或者一百萬。)

5.4 Short-term borrowing

5.4.1 Short-term cash requirements can also be funded by borrowing from the bank. There
are two main sources of bank lending:
(a) Bank overdraft
(b) Bank loans
5.4.2 Bank overdrafts are mainly provided by the clearing banks and are an important
source of company finance.

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Advantages Disadvantages
 Flexibility  Repayable on demand
 Only pay for what is used, so  May require security, e.g. floating
cheaper charges or personal guarantee
 Variance finance costs

5.4.3 Bank loans are a contractual agreement for a specific sum, loaned for a fixed period, at
an agreed rate of interest. They are less flexible and more expensive than overdrafts
but provide greater security.

6. Strategies for Funding Working Capital

(Pilot, Jun 09, Dec 09, Jun 12)
6.1 Introduction

6.1.1 It also named as working capital funding policy or working capital financing
strategy.
6.1.2 In the same way as for long-term investments, a firm must make a decision about what
source of finance is best used for the funding of working capital requirements. The
company will have access to both short-term finance (overdrafts, bank loans and trade
credit as previously discussed) and longer-term sources such as debentures and equity.

6.2 Permanent and fluctuating current assets

6.2.1 Current assets can be divided into permanent current assets and fluctuating current
assets.

6.2.2 Permanent and fluctuating current assets

(a) Permanent current assets represent the core level of investment in current
assets needed for a given level of business activity, and arise from the need
for businesses to carry stock and to extend credit. For example:
(i) buffer stock
(ii) receivables during the credit period
(iii) minimum cash balances.
(b) Fluctuating current assets represent a variable need for investment in
current assets, arising from either seasonal or unpredictable variations in
business activity.

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6.2.3 Traditionally current assets were seen as short-term and fluctuating and best
financed out of short-term credit which could be paid off when not required. Long-
term finance was used for non-current assets, since it involves committing for a
number of years and is not easily reversed.

6.2.4 If growth is included in the analysis, a more realistic picture emerges:

6.2.5 The choice of how to finance the permanent current assets is a matter for
managerial judgement, but includes an analysis of the cost and risks of short-term
finance.

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6.3 Aggressive, conservative and matching funding policies

6.3.1 There is no ideal funding package, but three approaches may be identified.
(a) Aggressive approach
(b) Conservative approach
(c) Matching approach

6.3.2 Aggressive approach

(a) This approach would emphasize short-term finance as the main source of
working capital funds, i.e. uses short-term finance for fluctuating
current assets and some permanent current assets, with long term finance
being used for the balance of permanent current assets and non-current
assets.
(b) This increases the relative amount of higher-risk short-term finance used
by the company, but will also incur lower total interest payments than the
conservative approach, leading to relatively higher profitability.
(c) Another disadvantage of this policy is an increase in the chances of
system breakdown through running out of inventory of loss of goodwill
with customers and suppliers.

6.3.3 Conservative approach

(a) This approach would emphasize long-term finance as the main source of
working capital funds. It would use long-term finance for non-current
assets, permanent current assets and some fluctuating current assets.
(b) Long-term finance is less risky to a company than short-term debt finance,
since once in place it is not subjected to the dangers of renewal or
immediate repayment, but is more expensive in that the rate of interest
charged normally increases with maturity.
(c) Therefore, it would lead to relatively lower profitability.

6.3.4 Moderate or matching approach

(a) This approach is matched the maturity of the funding with life of the
assets financed.
(b) Here, long-term finance is used for permanent current assets and non-
current assets, while short-term finance is used for fluctuating current

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assets.

6.3.5 Other factors that influence a working capital funding policy

(a) Management attitudes to risk – it will determine whether there is a

preference for a conservative, an aggressive or a matching approach.
(b) Previous funding decisions – it will determine the current position being
considered in policy formulation.
(c) Organization size – it will influence its ability to access different sources
of finance. A small company, for example, may be forced to adopt an
aggressive working capital funding policy because it is unable to raise
additional long-term finance, whether equity or debt.

6.3.6 Example 6
The following three companies have current asset financing structures that may be
considered as aggressive, average and defensive (conservative):

Statement of financial position

Aggressive Average Defensive
$000 $000 $000
Non-current assets 50 50 50
Current assets 50 50 50
100 100 100

Equity (50,000 $1 shares) 50 50 50

Long-term debt (average cost
10% pa) - 25 40
Current liabilities (average cost
3% pa) 50 25 10
100 100 100

Current ratio 1:1 2:1 5:1

Income statement $ $ $
EBIT 15,000 15,000 15,000
Less: Interest 1,500 3,250 4,300
Earnings before tax 13,500 11,750 10,700

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Tax @ (say) 40% 5,400 4,700 4,280

Total earnings 8,100 7,050 6,420

EPS 16.2c 14.1c 12.84c

The aggressive company is so termed as it is prepared to take the risk of financing

more of its business investment with short-term credit. The defensive company, at
the other ‘extreme’, takes on board a high proportion of longer-term debt with,
consequently, less short-term credit risk.

It can be seen that the aggressive company returns a higher profit but at the cost of
greater risk. It is interesting to note that this higher risk is revealed in its relatively
poor current ratio.

Multiple Choice Questions

13. Which statement best reflects an aggressive working capital finance policy?

A More short-term finance is used because it is cheaper although it is risky.

B Investors are forced to accept lower rates of return.
C More long-term finance is used as it is less risky.
D Inventory levels are reduced.

14. What are the 2 key risks for the borrower associated with short-term working capital
finance?

A Interest rate risk and renewal risk

B Inflexibility and rate risk
C Renewal risk and inflexibility
D Maturity mismatch and renewal risk

15. Which of the following statements concerning working capital management are
correct?

1 The twin objectives of working capital management are profitability and

liquidity
2 A conservative approach to working capital investment will increase profitability
3 Working capital management is a key factor in a company’s long-term success

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A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(ACCA F9 Financial Management Pilot Paper 2014)

16. Which of the following statements is true?

Statement 1: An aggressive working capital investment policy aims to finance most

of its current assets with long term finance.
Statement 2: A conservative working capital investment policy aims to finance most
of its current assets with short term finance.

Statement 1 Statement 2
A True True
B True False
C False True
D False False

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Additional Examination Style Questions

Question 5 – Long and Short Term Financing and Cash Operating Cycle
Blin is a company listed on a European stock exchange, with a market capitalisation of €6m,
which manufactures household cleaning chemicals. The company has expanded sales quite
significantly over the last year and has been following an aggressive approach to working
capital financing. As a result, Blin has come to rely heavily on overdraft finance for its short-
term needs. On the advice of its finance director, the company intends to take out a long-term
bank loan, part of which would be used to repay its overdraft.

Required:

(a) Discuss the factors that will influence the rate of interest charged on the new bank loan,
making reference in your answer to the yield curve. (9 marks)
(b) Explain and discuss the approaches that Blin could adopt regarding the relative
proportions of long- and short-term finance to meet its working capital needs, and
comment on the proposed repayment of the overdraft. (9 marks)
(c) Explain the meaning of the term ‘cash operating cycle’ and discuss its significance in
determining the level of investment in working capital. Your answer should refer to the
working capital needs of different business sectors.
(7 marks)
(Total 25 marks)
(ACCA 2.4 Financial Management and Control June 2004 Q2)

Question 6 – Working Capital Financing Strategies, Cash Budgets and Risks of

Granting Credit to Foreign Customers

The following financial information relates to HGR Co:

Statement of financial position at the current date (extracts)
$000 $000 $000
Non-current assets 48,965
Current assets
Inventory 8,160
Accounts receivable 8,775
16,935
Current liabilities
Overdraft 3,800

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Accounts payable 10,200

14,000
Net current assets 2,935
Total assets less current liabilities 51,900

Cash flow forecasts from the current date are as follows:

Month 1 Month 2 Month 3

Cash operating receipts ($000) 4,220 4,350 3,808
Cash operating payments ($000) 3,950 4,100 3,750
Six-monthly interest on traded bonds ($000) 200
Capital investment ($000) 2,000

The finance director has completed a review of accounts receivable management and has
proposed staff training and operating procedure improvements, which he believes will reduce
accounts receivable days to the average sector value of 53 days. This reduction would take six
months to achieve from the current date, with an equal reduction in each month. He has also
proposed changes to inventory management methods, which he hopes will reduce inventory
days by two days per month each month over a three-month period from the current date. He
does not expect any change in the current level of accounts payable.

HGR Co has an overdraft limit of $4,000,000. Overdraft interest is payable at an annual rate
of 6·17% per year, with payments being made each month based on the opening balance at
the start of that month. Credit sales for the year to the current date were $49,275,000 and cost
of sales was $37,230,000. These levels of credit sales and cost of sales are expected to be
maintained in the coming year. Assume that there are 365 working days in each year.

Required:
(a) Discuss the working capital financing strategy of HGR Co. (7 marks)
(b) For HGR Co, calculate:
(i) the bank balance in three months’ time if no action is taken; and
(ii) the bank balance in three months’ time if the finance director’s proposals are
implemented.
Comment on the forecast cash flow position of HGR Co and recommend a suitable
course of action. (10 marks)
(c) Discuss how risks arising from granting credit to foreign customers can be managed and
reduced. (8 marks)

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(Total 25 marks)
(ACCA F9 Financial Management June 2009 Q3)
Question 7 – Role of Financial Intermediaries, Financial Statement Forecasts, Working
Capital Financing Policy and Financial Performance Forecasts
APX Co achieved a turnover of $16 million in the year that has just ended and expects
turnover growth of 8·4% in the next year. Cost of sales in the year that has just ended was
$10·88 million and other expenses were $1·44 million.

The financial statements of APX Co for the year that has just ended contain the following
statement of financial position:
$m $m
Non-current assets 22.0
Current assets
Inventory 2.4
Trade receivables 2.2
4.6
Total assets 26.6

Equity finance:
Ordinary shares 5.0
Reserves 7.5
12.5
Long-term bank loan 10.0
22.5
Current liabilities
Trade payables 1.9
Overdraft 2.2
4.1
Total equity and liabilities 26.6

The long-term bank loan has a fixed annual interest rate of 8% per year. APX Co pays
taxation at an annual rate of 30% per year.

The following accounting ratios have been forecast for the next year:
Gross profit margin: 30%
Operating profit margin: 20%
Dividend payout ratio: 50%

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Inventory turnover period: 110 days

Trade receivables period: 65 days
Trade payables period: 75 days

Overdraft interest in the next year is forecast to be $140,000. No change is expected in the
level of non-current assets and depreciation should be ignored.

Required:

(a) Discuss the role of financial intermediaries in providing short-term finance for use by
business organisations. (4 marks)
(b) Prepare the following forecast financial statements for APX Co using the information
provided:
(i) an income statement for the next year; and
(ii) a statement of financial position at the end of the next year. (9 marks)
(c) Analyse and discuss the working capital financing policy of APX Co. (6 marks)
(d) Analyse and discuss the forecast financial performance of APX Co in terms of working
capital management. (6 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2009 Q4)

Question 8 – Expected value and Working Capital Management

ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two periods.
It has been experiencing considerable volatility in cash flows in recent periods because of
trading difficulties experienced by its customers, who have often settled their accounts after
the agreed credit period of 60 days. ZSE has also experienced an increase in bad debts due to
a small number of customers going into liquidation.

The company has prepared the following forecasts of net cash flows for the next two periods,
together with their associated probabilities, in an attempt to anticipate liquidity and financing
problems. These probabilities have been produced by a computer model which simulates a
number of possible future economic scenarios. The computer model has been built with the
aid of a firm of financial consultants.

Period 1 cash flow Probability Period 2 cash flow Probability

$000 $000
8,000 10% 7,000 30%
4,000 60% 3,000 50%

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(2,000) 30% (9,000) 20%

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.

Required:

(a) Calculate the following values:

(i) the expected value of the period 1 closing balance;
(ii) the expected value of the period 2 closing balance;
(iii) the probability of a negative cash balance at the end of period 2;
(iv) the probability of exceeding the overdraft limit at the end of period 2.
Discuss whether the above analysis can assist the company in managing its cash flows.
(13 marks)
(b) Identify and discuss the factors to be considered in formulating a trade receivables
management policy for ZSE Co. (8 marks)
(c) Discuss whether profitability or liquidity is the primary objective of working capital
management. (4 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2010 Q1)

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