CHAPTER – 10

WORKING CAPITAL MANAGEMENT –

CASH AND FUNDING STRATEGIES

Reasons for Holding Cash

Although cash needs to be investment to erns, businesses need to keep a certain
amount readily available. The reasons include:
• Transactions motive
• Precautionary motive
• Investment (speculative) motive.

Failure to carry sufficient cash levels can lead to:

• Loss of settlement discounts
• Loss of supplier goodwill
• Poor industrial relations
• Potential liquidation.

Cash Budgets and Cash Flow Forecasts

A cash forecast is an estimate of cash receipts and payments for a future period
under existing conditions.
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.
Cash budgets are used to:
• Assess and integrate operating budgets.
• Plan for cash shortages and surpluses.
• Compare with actual spending.

Cash forecasts can be prepared based on:

• Receipts and payments forecast.
• Statement of financial position forecast.
• Working capital ratios.

Proforma
Step 1 – Prepare a Proforma

Month: 1 2 3 4
$ $ $ $
Receipts X X X X

(few lines) X X X X

Sub total X X X X

Payments X X X X

(Many lines) X X X X

Sub total X X X X

Net cash flow X X X X

X X X X
Opening balance
X X X X
Closing balance

In the near future, a company will purchase a manufacturing business for $315,000,
this price to include goodwill ($150,000), equipment and fittings ($120,00), and
inventory of raw materials and finished goods ($45,000).
A delivery van will be purchased for $15,000 as soon as the business purchase is
completed. The delivery van will be paid for in the second month of operations.

The following forecasts have been made for the business following purchase:
i. Sales (before discounts) of business’s single product, at a mark-up of 60% on
production cost will be:

Month 1 2 3 4 5 6
($000) 96 96 92 96 100 104

25% of sales will be for cash; the remainder will be on credit, for settlement in
the month following that of sale. A discount of 10% will be given to selected
credit customers, who represents 25% of gross sales.

Illustration
In the near future, a company will purchase a manufacturing business for $315,000,
this price includes goodwill ($150,000), equipment and fittings ($120,000), and
inventory of raw materials and finished goods ($45,000).
A delivery van will be purchased for $15,000 as soon as the business purchase is
completed. The delivery van will be paid for in the second month of operations.
The following forecasts have been made for the business following purchase:

i. Sales (before discounts) of business’s single product, at a mark-up of 60% on

production cost will be:

Month 1 2 3 4 5 6
($000) 96 96 92 96 100 104

25% of sales will be for cash; the remainder will be on credit, for settlement in
the month following that of sale. A discount of 10% will be given to selected
credit customers, who represents 25% of gross sales.
 ii. Production cost will be $5 per unit. The production cost will be made up of:

Raw materials $2.50

Direct labour $1.50
Fixed overhead $1.00

iii. Production will be arranged so that closing inventory at the end of any month is
sufficient to meet the sales requirements in the following month. A value of
$30,000 is placed on the business. This valuation is based on the forecast of
production cost per unit given in (ii) above.
iv. The single raw material will be purchased so that inventory at the end of a
month is sufficient to meet half of the following month’s production
requirements. Raw material inventory acquired on purchase of the business
($15,000) is valued at the cost per unit that is forecast as given in (ii) above.
Raw materials will be purchased on one month’s credit.
v. Costs of direct labour will be met as they are incurred in production.
vi. The fixed production overhead rate of $1.00 per unit is based upon a forecast
of the first year’s production of 150,000 units. This rate includes depreciation of
equipment and fitting on a straight-line basis over the next five years. Fixed
production overheads are paid in the month incurred.
vii. Selling and administration overheads are all fixed and will be $208,000 in the
first year. These overheads include depreciation of the delivery van at 30% per
year on a reducing balance basis, and paid in the month incurred, will the
exception of rent and rates. $25,000 is payable for the year ahead in month one
for rent and rates.

Required:
a) Prepare a monthly cash flow forecast. You should include the business
purchase and the first four months of operations following purchase.
b) Calculate the inventory, receivable, and payables balance at the end of the four-
month period. Comment briefly upon the liquidity situation.
The answer to this question can be found after the chapter summary diagram
at the end of this chapter,
Using A Statement of Financial Position
Preparing A Cash Flow Forecast from A Statement of Financial Position
Used to predict the cash balance at the end of a given period, this method will typically
require forecasts of:
• Changes to non-current assets (acquisitions and disposals)
• Future inventory levels
• Future receivables levels
• Future payable levels
• Changes to share capital and other long-term funding (e.g. bank loans)
• Changes to retained profits.

Preparing A Cash Flow Forecast from Working Capital Ratios

Working capital ratio can also be used to forecast future cash requirements.
The first stage is to use the ratio to work out the working capital requirement, as we
have already seen in the working capital management chapter.
This technique is used to help forecast overall cash flow. The proforma below is used.

$
Operating profit X
Add: Depreciation X

Cash flow from operations X

Add: Cash from sale of non-current assets X
Long-term finance raised X
Less: Purchase of non-current assets (X)
Redemption of long-term funds (X)
Interest paid (X)
Tax paid (X)
Dividend paid (X)
Increase in working capital (X)

Net cash flow X

Illustration
X Co had the following results for last year.

Statement of profit or loss $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 (extract)

$m $m
Non-current assets 480
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
Trade payable days 50 days
Depreciation will be $15m.

Required:
Prepare a cash flow projection for the forthcoming period.

The answer to this question can be found after the chapter summary diagram at
the end of this chapter.

Cash Management Model

Cash management models are aimed at minimising the total costs associated with
movements between:
• A current (very liquid but not earning interest) and
• Short-term investments (less liquid but earning interest).

The models are devised to answer the questions:

• A what point should founds be moved is one go?
• How much should be moved in one go?

The Baumol Cash Management Model

Baumol noted that cash balances are very similar to inventory levels, and developed
a model based on the economic order quantity (EOQ).

Assumptions:
• Cash use is steady and predictable.
• Cash inflows are known and regular.
• Day-to-day cash needs are funded from current account.
• Buffer cash is held in short-term investments.
The formula calculates the amount of funds to inject into the current account or to
transfer into short-term investment at one time:

Q = √2𝐶𝑜𝐷 ∕ 𝐶ℎ

Co = transaction costs (Brokerage, commission, etc.)

D = demand for cash over the period
Ch = cost of holding cash

The model suggests that when interest rates are high, the cash balance held in non-
interest-bearing current accounts should be low. However, its weakness is the
unrealistic nature of the assumptions on which it is based.

The Miller-Orr Cash management Model

The Miller-Orr Model controls irregular movements of cash by the setting of upper
and lower control limits on cash balances.
The Miller-Orr model is used for setting the target cash balance.
It has the advantage (over the Baumol model) of incorporating uncertainty in the cash
inflow and outflows and so may be more appropriate than the Baumol model when
cash flows are erratic.
The lower limit, L is set by management depending upon how much risk of a cash
shortfall the firm is willing to accept.

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

Spread = 3 × [(𝟑/𝟒 × 𝑻𝒓𝒂𝒏𝒔𝒂𝒄𝒕𝒊𝒐𝒏 𝒄𝒐𝒔𝒕 × 𝑽𝒂𝒓𝒊𝒂𝒏𝒄𝒆 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘) ÷

𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆] ∧ 𝟏/𝟑

Variance and interest rates should be expressed in daily terms. If the question
provides you with the standard deviation of daily cash flow, you will need to square
this number this number to obtain the variance.

Q.3)
The minimum cash balance of $20,000 is required a Miller-Orr 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 squired) is $9 million. The interest rate is 0.03% per
day.

Calculate:
i. The spread between the upper and lower limits
ii. The upper limit
iii. The return limit.

Q.4)
A company sets its minimum cash balance at $5,000 and has estimated the following:
• Transaction cost = $15 per sale or purchase of gilts
• Standard deviation of cash follow = $1,200 per day (i.e. variance = $1.44 million
per day)
• Interest rate = 7.3% per year = 0.02% per day.

i. What is the spread between the upper and lower limits?

ii. What is the upper limit?
iii. What is the return point?
Short-term Cash Investments
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.

The objectives can be categorised as follows:

Liquidity: the cash must be available for use when needed.
Safety: no risk of loss must be taken.
Profitability: subject to the above, the aim is to earn the highest possible after-tax
returns.

The Liquidity Problem Is bridging finance

available to fill any gaps?
Are there penalties for
early withdrawal?

LIQUIDITY

Are there significant changes

How long before the sum
in returns as duration of
is needed again?
investment changes?

The Safety Problem

RISK

Is the cash best invested Is there a risk losing some

in a foreign currency? of the capital?

Is the future spending

subject to inflationary
risk?
 Fixed or variable interest
rate?

Term to maturity? Tax implications?

PROFITABILITY

Ability to find favorable

Better in another
rates?
currency?
Ability to forecast funds?

Calculation Of Repayment on A Loan

The annual repayments on a loan can be calculated using the annuity factors seen in
chapter 3. For example, a $100,000 loan taken out by a business at a rate of 7%.
Repayable over 5 years will have annual repayments of:
Annual payment = $100,000/4. 100 = $24,390.25
Where 4. 100 is the 5-year, 7% annuity factor.
Each payment can then be split between the repayment of capital and interest on the
outstanding balance.

Strategies for Funding Working Capital

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 decision about whether to choose short-or long-term options depends upon a
number of factors:
• The extent to which current assets are permanent or fluctuating.
• The costs and risks of short-term finance
• The attitude of management to risk
In most business a proportion of the current assets are fixed over time, i.e.
‘permanent’. For example:
• Buffer inventory,
• Receivable during the credit period,
• Minimum cash balances.

The Attitude of Management to Risk – Aggressive, Conservative

and Matching Funding Policies
There is no ideal funding package, but three approaches may be identified.

• Aggressive – finance most current assets, including ‘permanent’ ones, with

short-term finance. Risky but profitable (as the finance is cheaper).
• Conservative – long-term finance is used for most current assets, including a
proportion of fluctuation current assets. Stable but expensive.
• Matching – the duration of the finance is matched to the duration of the
investment.

Illustration – Aggressive, Conservative and Matching Fuding Policies

The following three companies have current asse financing structures that may be
considered as aggressive, matching and conservative:

Statement of Financial Position

Aggressive Matching Conservative

$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% per year) - 25 40
Current liabilities (average cost 3% per year) 50 25 10
100 100 100
Current ratio 1:1 2:1 5:1
Statement of Profit or Loss
$ $ $
EBIT 15,000 15,000 15,000
Less: Interest 1,500 3,250 4,300
Earning before tax 13,500 11,750 10,700
Corporation tax @ (say) 40% 5,400 4,700 4,280
Earning available to equity 8,100 7,050 6,420
Earning per shares (EPS) 16.2c 14.1c 12.84c

Smaller companies may, by necessity, finance almost all their needs from short-term
finance, since long-term debt and equity may be difficult to raise without marketable
shares, few assets to use as security and a good track record.
If the commercial sector in which the company operates has volatile earnings,
management may consider it best to take a conservative approach to funding to avoid
particular problems in problem years.

Q.5)
Which of the following should not be included in a cash follow 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 non-current asset

Q.6)
A company’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?
A. $24,500
B. $26,600
C. $28,000
D. $332,90
Q.7)
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.

Q.8)
In the Miller-Orr cash management model
Return point = Lower limit + ………………………………………………… × spread
A. One half
B. One third
C. One quarter
D. One fifth

Q.9)
Which of the following statement is true?

Statement 1: An aggressive working capital investment policy aim to finance

most of its current 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
Cash Forecast Using SOFP
Zed Co has the following statement of financial position at 30 June 20X3:
$ $
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
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 20X4.
b) The levels of inventories and receivables are expected to increase by 5% and
10% respectively by 30 June 20X4, due to business growth.
c) Trade payables and dividend liabilities are expected to be the same at 30 June
20X4.
d) No share issue is planned, and retained profits for the year to 30 June 20X4
are expected to be $42,000.
e) Plant and machinery is depreciated on a reducing balance basis at the rate of
20% per year, for all assets held at the statement of financial position date.
Required:
Produce a financial position statement forecast as at 30 June 20X4, and predict what
the cash balance or bank overdraft will be at the date. The answer to this question can
be found after the chapter summary diagram at the end of the chapter.