TOPIC THREE

3. WORKING CAPITAL MANAGEMENT

3.1. Introduction to Working Capital Management
Effective working capital management allows a business to:
 Operate smoothly
 Fulfill obligations and
 Avoid cash flow issues which directly impacts its profitability and financial health.

3.1.1. Key Components of Working Capital

A. Current Assets: - Assets expected to be converted into cash or used up within one
accounting period. Include cash, marketable securities, accounts receivable and
inventory.
 Cash and Cash Equivalents - Necessary for day-to-day expenses and
unexpected obligations.
 Accounts Receivable: Money owed to the company by customers. Effective
receivables management focuses on minimum time between sales and cash
collection.
 Inventory: Goods and materials the business holds to sell or use in production.
Effective inventory management avoids excess stock and stock outs.

B. Current Liabilities - Obligations the company needs to settle within one accounting
period. Include accounts payable, accrued expenses and short-term loans.
 Accounts Payable - Money the business owes to suppliers.
 Short-term Loans and Accrued Expenses - Managing short-term obligations
while balancing cash flow needs is crucial.

3.1.2. Working Capital Defined:

The funds a company needs to cover its short-term operational expenses. Expressed as
the difference between current assets and current liabilities.
 WORKING CAPITAL = CURRENT ASSETS − CURRENT LIABILITIES

3.1.3. Objectives of Working Capital Management

The goal of working capital management include:
i) Ensuring Liquidity - To sure the firm has enough cash flow to cover short-term
obligations for smooth operations and ability to capitalize on new opportunities or
emergencies.
ii) Optimizing Profitability – increasing profitability by reducing costs (such as interest
on borrowed funds) and optimizing cash flow to reinvest in growth opportunities.
iii) Minimizing Risk – A balanced working capital reduces the risk of financial distress.

3.1.4. Importance of Working Capital Management in Corporate Finance

i) Improves Cash Flow - Ensures sufficient cash for operational needs and reduces
the likelihood of cash shortages.
ii) Reduces Financing Costs - Efficient management minimizes the need to borrow,
reducing the interest expenses associated with short-term loans.
 iii) Supports Business Growth - Improved receivables, inventory and payables
management allows the company to reinvest in growth opportunities.
iv) Enhances Profitability - Helps avoid the costs of excess inventory, overdue
receivables, and untapped payable opportunities. This directly impact profitability.
v) Strengthens Creditworthiness - A business that manages its working capital well is
more likely to meet obligations on time which can improve its credit rating and
access to financing.
vi) Financial Flexibility: Allows the firm to respond quickly to unexpected opportunities
or challenges.

3.1.5. Key Strategies in Working Capital Management

i) Cash Management: Ensuring sufficient cash is available for daily operations without
holding too much to tie up resources by forecasting cash flows, managing payment
schedules, and optimizing bank relationships.
ii) Receivables Management: Set clear credit policies, monitor accounts receivable
turnover and use collections strategies to minimize overdue receivables (e.g.
Offering discounts for early payments).
iii) Inventory Management: Balance inventory levels to avoid stock outs or excess
inventory is crucial. Use Just-in-Time (JIT) inventory, safety stock and Economic
Order Quantity (EOQ) models.
iv) Payables Management: Extend payment terms with suppliers (without jeopardizing
relationships) to conserve cash.
v) Working Capital Cycle (Cash Conversion Cycle): Measures the time it takes for a
company to convert its resources into cash flows.
 Formula: Cash Conversion Cycle (CCC) = DSO + Inventory Days - DPO
 A shorter CCC indicates a more efficient working capital management.
 DSO = day sales outstanding, DPO = Day payable outstanding

3.1.6. Working Capital Policies

i) Aggressive Policy - Holds minimal working capital, freeing more funds for investment.
It increases both profitability and liquidity risk.
ii) Conservative Policy: Maintains high levels of working capital and using long-term
financing for a larger portion of working capital. It lowers both liquidity risk and
profitability due to the costs of holding excess assets.
iii) Moderate (or Matching) Policy: Balancing between liquidity and profitability by keeping
optimal levels of working capital.

3.1.7. Techniques and Tools for Working Capital Management

A. Ratio Analysis:
Current Assets
 Current Ratio: Current Liabilities

i) It Measures liquidity.
ii) The higher ratio indicates strong liquidity but may mean excess assets, while
a lower ratio signals potential liquidity problems

Current Assets−Inventory
 Quick Ratio (Acid Test): Current Liabilities
 It Measures short-term liquidity excluding inventory.

 Accounts Receivable Turnover Ratio:

CNet Credit sales
i) Receivables Turnover = Average SAccounyt receivables
ii) High turnover indicates efficient collection.

 Inventory Turnover Ratio:

Cost of Goods Sold
Inventory Turnover =
Average Inventory
i) High turnover suggests effective inventory management
ii) Low turnover may indicate overstocking.

B. Cash Flow Forecasting: Predicting future cash inflows and outflows for preventing
cash shortages.

C. Working Capital Financing Options:

 Trade Credit: Credit extended by suppliers, often the first source of working
capital financing.
 Short-Term Loans: Bank loans and credit lines to cover temporary shortfalls.
 Factoring and Invoice Discounting: Selling or discounting receivables to get
immediate cash.
D. Cash Conversion Cycle (CCC)
 CCC = Days Inventory Outstanding +Days Sales Outstanding − Days Payable Outstanding
 A shorter CCC indicates that the company efficiently turns resources into cash.

3.1.8. 6. Challenges in Working Capital Management

 Seasonality: Fluctuating cash flows can create periods of surplus or shortage.
 Credit Risk: Extending credit to customers can lead to bad debts and delayed
collections.
 Economic and Market Conditions: Inflation, interest rates, and market demand
can impact inventory and receivable management.
 Supply Chain Disruptions: External events can lead to delays, affecting inventory
and production cycles.

3.2. PRINCIPLES UNDERLYING EFFECTIVE MANAGEMENT OF WORKING CAPITAL

Effective working capital management is guided by a few key principles which aim to
balance liquidity and profitability. The following are the core principles underlying effective
working capital management:

3.2.1. Principle of Liquidity

 To ensure that the company has enough cash or cash equivalents to meet its short-
term obligations.
 To avoid liquidity crises and ensures smooth day-to-day operations
 To minimizes the need for external financing and keeps working capital costs low.
 Choose between conservative (higher liquidity), aggressive (lower liquidity) or
moderate strategies for working capital to match the company's specific goals and
risk profile
3.2.2. Principle of Inventory Levels Optimization
 To maintain inventory at levels that satisfy demand to reduce capital tied up in
inventory and lowers holding costs.
 Avoid overstocking (ties up capital) and/or stockouts (loss of customers).
 Apply inventory control methods (Just-in-Time (JIT) or Economic Order Quantity
(EOQ) to reduce holding costs and improve turnover rates.

3.2.3. Principle of Profitability

 Objective: Balance liquidity needs with profitability.
 It encourages companies to allocate resources effectively (minimizing idle cash or
inventory and collecting receivables quickly), to have more capital available for
growth or other investments.

3.2.4. Principle of Cost-Effectiveness

 To reduce the overall cost of capital and working capital.
 For Cost of Capital: Utilize trade credit, negotiate favorable terms with suppliers,
and seek out short-term loans or credit lines with minimal interest
 For Working capital: Reduces the costs associated with holding and financing
current assets. (avoid overstocking, optimizing receivables and payables to limit the
need for costly short-term financing).

3.2.5. Principle of Risk Management

 To mitigate the risks associated with working capital investments.
 Manage credit risk (for receivables), inventory obsolescence and interest rate risk
on short-term financing.
 Apply credit policies, inventory management techniques and hedging strategies to
mitigate the risks and protect cash flow.

3.2.6. Principle of Flexibility

 Maintain flexibility to adapt to changes in market conditions or company needs.
 Set flexible working capital policies to enable a company to scale its short-term
assets and liabilities as needed to take advantage of opportunities and respond to
changes (fluctuations in demand or supply chain issues).

3.2.7. Principle of Timing (Cash Conversion Cycle Management)

 To minimize the cash conversion cycle (CCC) to improve overall cash flow.
 To measures how quickly a company can convert its investments (inventory and
other resources) into cash by optimizing the three key components (inventory days,
receivable days and payable days).

3.2.8. Principle of Balanced Receivables and Payables

 To align the terms of accounts receivable and accounts payable to optimize cash
flow and minimize financing needs and minimizes credit risk.
 Set credit policies that reduce Days Sales Outstanding (DSO) while maintaining
customer relationships.
  Negotiate favorable payment terms with suppliers to extend Days Payable
Outstanding (DPO) without penalties.

3.3. THE WORKING CAPITAL POLICIES AND ITS IMPACT OF EACH ON PROFITABILITY AND
LIQUIDITY POSITION OF THE BUSINESS
 Working capital policies dictate how a company manages its short-term assets and
liabilities which impact both profitability and liquidity.
 Three main working capital policies: conservative, aggressive and moderate.
 Each has a unique approach to balancing liquidity and profitability, influencing the
company’s financial stability and ability to generate profits.

3.3.1. Conservative Working Capital Policy

 It prioritizes high liquidity - the company maintains a larger amount of current
assets (cash and inventory) relative to current liabilities.
 It reduces risk by ensuring funds are readily available to meet short-term obligations.
 Impact on Liquidity:
i) High liquidity: The company is readily equipped to cover expenses, even during
economic downturns due to more cash and other liquid assets available.
ii) Lower risk of insolvency: with high level of current assets there is low risk of
failing to meet short-term debts.
 Impact on Profitability
i) Lower profitability: Excessive liquid assets (cash) are not invested in high-
return opportunities limiting overall profitability.
i) Higher holding costs: Holding large inventories incurs additional storage and
management costs reducing net income.
 Overall Trade-off: A conservative policy favors liquidity and stability over
profitability, making it ideal for businesses in volatile markets but less suitable for
maximizing returns.

3.3.2. Aggressive Working Capital Policy

 It minimizes current assets and relies heavily on short-term financing to free up
capital for other high-return investments.
 There is minimal cash reserves and inventory levels. Payables are extended as much
as possible to conserve cash.
 Impact on Liquidity
i) Lower liquidity: Fewer liquid assets reduces cash availability to cover
immediate expenses or debt obligations.
ii) Higher risk of insolvency: Short-term financing leads to liquidity issues during
unforeseen events or if short-term credit becomes unavailable.
 Impact on Profitability:
i) Higher profitability: More funds are available for revenue-generating
investments potentially increasing returns due to less capital tied up in low-
return assets.
ii) Lower holding costs: There is lower costs associated with storage, insurance
and maintenance which can enhance profit margins as inventory and
receivables are limited.
  Overall Trade-off: An aggressive policy is more profitable at the expense of
liquidity. making it riskier. It’s often suitable for businesses in stable industries with
predictable cash flows but can be dangerous for firms in more volatile sectors.

3.3.3. Moderate Working Capital Policy

 It strikes a balance between conservative and aggressive approaches.
 It maintains an optimal level of current assets to support both liquidity and
profitability.
 Enough cash, inventory and other current assets are involved to meet day-to-day
needs while not over-investing in them.
 Impact on Liquidity
i) Balanced liquidity: The company maintains enough liquid assets to meet
obligations without the risk of excessive cash shortages.
ii) Reduced insolvency risk: This balanced approach reduces the chances of
liquidity crises while still freeing up some capital.
 Impact on Profitability:
i) Moderate profitability: Additional funds are available for investments for
reasonable profit generation.
ii) Controlled holding costs: Lower storage and opportunity costs due to moderate
management of inventory and receivables.

 Overall Trade-off:
i) It offers a compromise, balancing liquidity and profitability to provide a
stable and sustainable working capital position.
ii) Often preferred for companies that seek both stability and growth
potential.

Summary: Impacts of Policies on Profitability and Liquidity

Policy Liquidity Impact Profitability Impact Best For
High liquidity, low Lower profitability, Businesses in volatile or
Conservative
risk higher costs uncertain markets
Lower liquidity, Higher profitability, Stable industries with
Aggressive
higher risk lower costs predictable cash flows
Moderate Companies seeking a
Balanced liquidity
Moderate profitability and balanced approach
and risk
costs between risk and return
3.4. DETERMINANTS OF THE WORKING CAPITAL POLICY OF BUSINESSES
The working capital policy of a business, which dictates how much current assets and
liabilities to be maintained is influenced by several determinants factors. They help to adopt
whether a conservative, aggressive or moderate approach to working capital.

The following are the key determinants of a company’s working capital policy:
3.4.1. Nature of the Business
 The industry and type of business significantly impact working capital needs.
 High inventory requirements Companies (manufacturing and retail) need more working
capital.
 Service-based companies require less due to minimal inventory needs.
 Capital-intensive businesses prefer a conservative working capital policy to ensure
enough liquidity (a grocery store with high inventory turnover and daily cash sales)
 Service-oriented businesses adopt a more aggressive policy (a consulting firm with
few physical assets).

3.4.2. Business Cycle and Seasonality

 Companies with cyclical or seasonal demand face fluctuating working capital
requirements.
 During peak seasons, need more working capital to cover higher inventory and receivable
levels.
 During the off-season, it can maintain lower working capital
 Seasonal businesses may adopt a flexible working capital policy which adjusts
during peak periods. (Upcountry transporters needs more working capital during
the year-end holiday season to meet increased demand)
 Steady demand business can afford a more aggressive approach.

3.4.3. Growth and Expansion Plans

 Companies experiencing high growth or planning expansions often need additional
working capital to support increased inventory, receivables and other current assets.
 Growth-oriented businesses often adopt a more conservative policy to ensure adequate
liquidity to avoid cash flow constraints during expansion. (a rapidly growing e-commerce
company may need extra working capital to support larger inventory and distribution
requirements).

3.4.4. Credit Policy and Terms of Trade

 A company’s credit policy affects the level of accounts receivable.
 Firms offering longer credit terms may adopt a more conservative working capital
policy to support higher receivables (a company that offers generous credit terms e.g.,
60-day payment terms) will have higher accounts receivable)
 Firms with cash-only sales may adopt a more aggressive policy.

3.4.5. Inventory Management Practices

 Efficient inventory management reduces the need for high working capital.
 Less cash is tied up in stock.
 Businesses with efficient inventory practices can adopt a more aggressive policy (a
manufacturer using JIT inventory will keep minimal stock),
 Business with less efficient or fluctuating inventory requirements may prefer a
conservative approach.

3.4.6. Credit Availability and Financial Markets

 Easy access to external financing reduces the need to hold high levels of working
capital.
 Companies can rely on short-term loans or credit lines during cash shortages.
 Firms with greater access to affordable financing may lean toward an aggressive policy
(if interest rates are low and credit is readily available, a company may rely more on
external financing rather than holding high cash reserves).
 Firms with limited credit access should adopt a conservative policy to avoid cash flow
disruptions.

3.4.7. Operating Cycle

 The length of a company’s operating cycle (time between purchasing inventory and
collecting cash from sales) determines how much working capital is needed.
 A longer cycle requires more capital to finance inventory and receivables.
 Companies with longer operating cycles generally adopt a conservative policy (a
furniture manufacturer with a long production and sales cycle needs more working
capital).
 Companies with shorter cycles can afford to be more aggressive with working capital (a
fast-food chain with a quick turnover).

3.4.8. Risk Tolerance and Management Attitude

 A risk-averse management team may prefer higher liquidity.
 A risk-taking team may prioritize profitability.
 Risk-averse companies are likely to adopt a conservative working capital policy (A
family-owned business with a conservative board may prioritize liquidity).
 Risk-tolerant companies may prefer an aggressive policy (high-growth tech startup).

3.4.9. Profit Margins

 Companies with higher profit margins may have more flexibility to adopt an aggressive
working capital policy to absorb the risk of potential liquidity issues.
 High-margin companies may adopt aggressive policies (A luxury brand with high profit
margins keeping lower inventory and receivables because profits can cover occasional
liquidity needs)
 Low-margin businesses might need conservative policies to avoid liquidity risks.

3.5. ESTIMATION OF THE WORKING CAPITAL REQUIREMENTS OF A FIRM

Estimating working capital requirements is crucial for ensuring that a company has enough
working capital. The following are the key methods and approaches commonly used to
estimate a firm's working capital needs.

3.5.1. Operating Cycle Method

 It estimates working capital based on the length of the company’s operating cycle
(time it takes to convert inventory and receivables back into cash).
 Steps:
 1. Calculate the duration of each stage in the operating cycle (inventory period,
receivables period, and payables period).
2. Estimate the average cost at each stage.
3. Multiply these costs by the respective durations.
 Formula:
 Working Capital Required =Inventory Period + Receivables Period − Payables Period
This method is effective for businesses with predictable operating cycles, such as
manufacturers or retailers.

3.5.2. 2. Percentage of Sales Method

 It estimates working capital as a percentage of projected sales, based on historical
data and industry benchmarks.
 Formula:
 Working Capital Requirement = Forecasted Sales × Working Capital Percentage.
 It is useful for firms with stable working capital-to-sales ratios and provides a
straightforward approach for planning, especially for growing businesses where sales
forecasts are reliable.

3.5.3. 3. Regression Analysis Method

 This statistical method uses historical data to establish a relationship between
working capital and various factors such as sales, cost of goods sold, and assets. A
regression equation is developed to predict working capital needs based on these
variables.
 The regression equation:
 Working Capital =a+b (Sales) + c (Assets)+…
 It is suitable for businesses with complex working capital requirements and multiple
influencing factors. However, it requires technical knowledge and reliable historical
data.

3.5.4. Cash Forecasting Method

 It involves estimating the cash flows for each component of working capital (cash,
receivables, inventory, payables) over a specific period.

Formula:
 Net Cash Flow = Total Cash Inflows − Total Cash Outflows
 It is suitable for short-term working capital planning particularly in dynamic or
seasonal businesses with fluctuating cash flows.

3.5.5. Working Capital Ratio Approach

 It involves calculating the company’s ideal current ratio (current assets divided by
current liabilities), which is then used to estimate required working capital.

Formula:
 Working Capital = Desired Current Ratio × Current Liabilities − Current Liabilities
 It is helpful when companies have clear benchmarks for desired liquidity levels,
making it easy to determine an appropriate working capital amount.
3.5.6. Operating Cycle or Working Capital Cycle Estimation
 It estimates the requirement based on the length of the working capital cycle,
factoring in each stage’s impact on cash flow (inventory, receivables, payables).
 Formula:
Inventory Cost Receivable Cost Payable Cost
Working Capital Requirement = Inventory Turnover
+ Receivable Turnover -Payable Turnover
 It is often used in capital-intensive or inventory-heavy businesses to capture the cash
needs of each stage in the working capital cycle.

Choosing the Right Method

Method Best for Limitations
Stable businesses with
Operating Cycle Method Assumes steady cash flows
predictable cycles
Growing companies with Limited by accuracy of sales
Percentage of Sales Method
stable ratios forecasts
Complex, multi-factor Requires technical skill and
Regression Analysis Method
dependent businesses historical data
Seasonal or cash flow- Difficult if cash flow is
Cash Forecasting Method
volatile businesses unpredictable
Working Capital Ratio Firms with clear industry Does not adjust for specific
Approach benchmarks cash flow timing
Capital-intensive or Relies on accurate turnover
Operating Cycle Estimation
inventory-heavy firms calculations

Worked Examples Calculation

A retail company expects annual sales of TZS 10 million, with historical data showing that
working capital is typically 20% of sales.
i) Using the Percentage of Sales Method, calculate the W/Capital requirement
ii) If the company has an operating cycle of 90 days, with TZS 1 million in inventory,
TZS 800,000 in receivables and TZS 600,000 in payables calculate the W/Capital
requirement using the Operating Cycle Method

Soln
i) Working Capital Requirement =10,000,000×0.20 = 2,000,000:
i) Working Capital Requirement = Inventory + Receivables - Payable
=1,000,000+800,000−600,000 =1,200,000
Each method provides a different perspective, and companies often use a combination
to confirm their estimates. Choosing the most appropriate method depends on the
business’s operational characteristics, cash flow patterns, and growth projections.

3.6. DECISION ON THE LEVEL OF INVENTORY

The decision on the level of inventory of the firm directly impacts a company’s
liquidity, profitability and operational efficiency.

3.6.1. Key Considerations in Setting Inventory Levels

1. Demand Forecasting – To ensure inventory is available to meet sales without
overstocking.
 .
2. Cost of Holding Inventory - Holding inventory incurs storage, insurance and
opportunity costs. Excessive inventory ties up capital that could be used
elsewhere.
3. Order Costs - Expenses associated with placing orders, processing and
logistics.
Lowering these costs can reduce the frequency and cost of restocking.
4. Lead Time - The duration between placing an order and receiving the inventory. A
longer lead time increases the need for higher safety stock to avoid stockouts.
5. Stockout Costs - Running out of inventory, can lead to lost sales, customer
dissatisfaction and even lost market share.
6. Inventory Turnover Ratios - It indicates how often inventory is sold and replaced
in a period, reflecting inventory efficiency.

3.6.2. Techniques for Determining Optimal Inventory Levels

1. Economic Order Quantity (EOQ) Model – It calculates the optimal order quantity to
minimize total inventory costs, including holding and order costs.
2× Demand × Order Cost
 EOQ = √
Holding Cost per Unit

It is suitable for businesses with consistent demand. It allows them to balance

ordering and holding costs effectively.

2. Just-in-Time (JIT) Inventory – It focuses on ordering goods only as needed for

production or sales.
This approach reduces holding costs and prevents excess inventory.
Suited for companies with reliable supply chains and stable demand.

3. Safety Stock Calculation – The extra inventory kept to cover demand fluctuations and
lead time uncertainties.
 Safety Stock = Zx σ (Demand)
Where Z= the desired service level (usually tied to a probability),
σ (sigma) = the demand standard deviation.
It is useful for businesses in unpredictable markets or with long lead times.

4. ABC Analysis – This method prioritizes inventory based on value and turnover.
"A" items are high-valued
"B" items are moderate valued,
"C" items are low-valued.
Focus resources on managing “A” items more closely while maintaining adequate
levels of “B” and “C” items.
It is ideal for companies with a diverse inventory allowing them to focus on high-
value items.

5. Reorder Point (ROP) Calculation

ROP is the inventory level at which a new order should be placed to replenish
stock before it runs out.
  Reorder Point = Lead Time Demand + Safety Stock
Used to manage stock replenishment and avoiding stockouts.

3.6.3. Effects of Inventory Levels on Financial Performance

1. Profitability
i) High Inventory Levels:  The higher the inventory level, the higher the
holding costs, the lower profitability due to tied-up capital and potential for
obsolescence.
ii) Low Inventory Levels: Insufficient inventory can lead to stockouts, missed
sales, and lost customer goodwill  reducing profitability.
2. Liquidity
i) High Inventory Levels:  The higher the inventory level, the lower the cash
available for other investments, potentially impacting a company’s liquidity.
ii) Low Inventory Levels: Lower inventory frees up cash but may lead to missed
opportunities if demand spikes unexpectedly.

3. Operational Efficiency
i) Optimal Inventory: Balancing inventory to match demand increases
operational efficiency, allowing smooth production and sales processes.
ii) Imbalance: Excess or insufficient inventory creates bottlenecks and disrupts
operations, potentially leading to increased costs.
4. Risk Management
i) High Inventory - Large stock levels can mitigate supply chain risks and meet
demand but increase the risk of obsolescence or spoilage.
ii) Low Inventory - Reduces risk of obsolescence but increases the risk of
stockouts during unexpected demand.

3.7. Credit Policy Variables and their Impact on the Wealth of Shareholders and Managing
Collections
 Credit policy is a set of guidelines that dictates how a company extends credit to its
customers
 A company’s credit policy defines the terms and conditions for extending credit to
customers, influencing sales, cash flow and profitability.
 A well-structured credit policy can maximize returns while maintaining manageable
levels of credit risk, directly impacting shareholder wealth and effective collections
management.

3.7.1. Key Credit Policy Variables

1. Credit Period - The amount of time given to customers to pay for their purchases.
 Extended credit period can attract more customers and boost sales but may delay
cash inflows increasing the risk of bad debts.
 Shorter credit periods improve liquidity and reduce the risk of non-payment but
may deter potential customers.
 A balanced credit period can enhance profitability resulting from sales growth and
higher cash flows, impacting shareholder wealth positively.
 2. Credit Standards - The criteria used to assess a customer’s creditworthiness,
determining
who qualifies for credit.
 It reduces the risk of default but may limit sales. Conversely, relaxed standards
can increase sales but at a higher risk of bad debts.
 Optimizing credit standards can reduce bad debt expenses and improve
profitability, enhancing shareholder value positively. However, overly restrictive
credit standards may lose sales opportunities and negatively affect revenue.

3. Discount Policy - Discounts offered for early payments to encourage customers to pay
before the due date.
 Offering discounts can accelerate cash inflows and reduce accounts receivable
days, improving liquidity. However, discounts reduce profit margins, so the policy
must be well-calibrated.
 If discounts lead to faster collections and lower accounts receivable costs, they
can positively impact cash flow and reduce borrowing needs, indirectly benefiting
shareholders.
 Excessive discounts however, erode profitability and shareholder wealth.

4. Collection Policy – A set of strategies (communication legal actions if necessary) taken

to collect overdue payments.
 A strict collection policy can minimize bad debts and accelerate cash flow but may
strain customer relationships.
 A lenient policy may maintain customer goodwill but increase default risk.
 Effective collections minimize bad debt losses and improve cash flow, preserving
shareholder value. Overly aggressive collections, however, may lead to lost
customers and impact future revenue.

5. Credit Limit - The maximum credit extended to a single customer based on their
financial strength and repayment history.
 Setting credit limits reduces the risk of high-value defaults, ensuring that large
sales aren’t overly reliant on customers with low creditworthiness.
 Properly managed credit limits help balance sales opportunities and risk impacting
positively profitability and shareholder wealth.

3.7.2. Managing Collections and Its Impact on Shareholder Wealth

Effective collection practices ensure that receivables are realized timely to improve
cash flow and reduce the need for external financing.

The key credit collection practices include:

 Timely Invoicing and Follow-ups - Prompt invoicing and follow-up reminders to
help customers stay aware of payment deadlines to reduce overdue accounts.
 Structured Communication – Set regular communication and automated reminders
to maintain customer relations while encouraging timely payments.
  Aging Analysis - Aging of receivables helps identify overdue accounts and focus
collection efforts on higher-risk receivables.
 Use of Technology: CRM and automated collection software can improve collection
efficiency, track payment behavior, and send reminders to optimize the collection
process.

3.7.3. Balancing Credit Policy and Shareholder Wealth

An optimal credit policy balances sales growth with effective risk management to
enhance shareholder wealth.
Key strategies Balancing Credit Policy and Shareholder Wealth
1. Maximizing Sales without Excessive Risk – Helps to achieve the right balance
between encouraging sales and minimizing bad debt risk.
2. Optimizing Cash Flow and Reducing Financing Costs – Helps to reduce days sales
outstanding (DSO), improving liquidity which minimizes the need for costly short-
term financing to preserve resources that benefit shareholders.
3. Minimizing Bad Debt Expenses: By maintaining appropriate credit standards, credit
limits, and collection efforts, a company can keep bad debt expenses low, thereby
enhancing profitability and shareholder wealth.

3.8. DETERMINATION OF THE OPTIMAL CASH BALANCE (BAUMOL’S AND MILLER-ORR

MODELS)
Two widely used models to determine the optimal cash balance are:
 The Baumol Model and
 The Miller-Orr Model.

They help to balance the trade-off between the opportunity cost of holding cash and
the transaction cost of converting other assets to cash.

3.8.1. Baumol Model of Cash Management

 Also known as the Economic Order Quantity (EOQ) model for cash determines the
optimal cash balance that minimizes the total cost of holding cash and the
transaction cost of converting securities or other assets into cash.
 It suites for firms with predictable cash flows.

Key assumptions of the Baumol Model

 Cash flows are steady and predictable.
 Cash usage is consistent over time.
 There are only two types of cash flows (cash inflows from sales and cash
outflows for purchases).
 The company can convert marketable securities to cash at a constant transaction
cost.

Formula for Optimal Cash Balance

The Model is based on the EOQ formula to calculates the optimal cash balance (C*).
 2 𝑥 𝑇𝑥𝐹
 C=√ 𝑟
Where:
C = Optimal cash balance
T = Total cash requirement over a period
F = Fixed transaction cost per transaction of converting securities to cash
r = Opportunity cost or interest rate of holding cash (annualized)

The formula means

1. Each time the company converts securities into cash, it incurs a fixed transaction
cost (F).
2. Holding cash incurs an opportunity cost, represented by the interest rate (r).
3. The Optimal Balance (C) minimizes the sum of these costs by balancing the
transaction cost and the opportunity cost.

Limitations of the Baumol Model

 It assumes a constant rate of cash usage, which may not be realistic for firms
with fluctuating cash flows.
 It assumes a constant transaction cost and interest rate which may not apply in
changing market conditions.

3.8.2. Miller-Orr Model of Cash Management

The Miller-Orr Model is more flexible than the Baumol Model and is suitable for firms
with unpredictable cash flows.
It establishes upper and lower control limits for cash balances for cash levels to
fluctuate within these limits.

Assumptions of the Miller-Orr Model

i) Cash flows are random and unpredictable.
ii) The firm incurs a fixed transaction cost whenever it buys or sells securities to
adjust its cash balance.
iii) There is an opportunity cost for holding cash.
iv) The cash balance has an upper and lower limit. On its upper limit, the firm invests
excess cash; But at its lower limit, it sells securities to replenish cash.

Components of the Model

i) Lower Limit (L) - The minimum acceptable cash balance. If the cash balance falls
below this level, the firm must transfer funds from marketable securities to
replenish cash.
ii) Upper Limit (H) - The maximum allowable cash balance. When cash exceeds this
level, surplus funds are invested in marketable securities.
iii) Return Point (Z) - The target cash balance, which lies between the upper and lower
limits. Whenever cash moves outside the bounds, it is adjusted back to this point.

The Miller-Orr Model uses the following formulas:

The formula for the spread, which determines the range between the upper and lower
limits for cash balances, is given by:
3𝑏σ2 1/3
1. Spread, S = 3x ( )
4𝑖
Where:
S = Spread (distance between the upper and lower limits of cash balance).
b = Fixed transaction cost for transferring funds.
σ2 = Variance of daily cash flows.
i = Opportunity cost of holding cash (daily interest rate)

2. Upper Limit, U = L+S

Where:
L = lower limit
S = spread

𝑆
3. Return point (Optimal/Target Cash Balance), Z = L+
3
4. The lower limit is usual set by the firm

 Upper Limit, U = 3Z−2L

3 𝑥 𝐹 𝑥 σ2
 Target Cash Balance, Z =√ 4𝑥𝑟
+L
Where:
 F = Fixed transaction cost per transaction
 σ2 = Variance of daily cash flows
 r = Opportunity cost or interest rate for holding cash
 L = Minimum cash balance (usually set by the firm)

Limitations of the Miller-Orr Model

 It requires the estimation of daily cash flow variance, which may be difficult for
firms without stable cash flow data.
 It assumes a constant transaction cost and interest rate, which may vary over
time.
 Worked Examples
1. Marwa Co. uses the Baumol model to manage its cash balances. The following information
is available:
i) Annual cash requirement is TZS2,400,000
ii) Fixed transaction cost is TZS100 per transaction
iii) Annual interest rate is 5%

Calculate:
a) The optimal cash transfer amount
b) The number of transfers required annually
c) The total annual cost of managing cash
2. Boke Company estimates the following
i) Annual cash requirement is TZS1,200,000
ii) Fixed transaction cost is TZS50
iii) Annual interest rate is 4%
The company is currently transferring TZS80,000 per transaction. Is this an optimal
strategy? If not, recommend the optimal cash transfer amount and calculate the savings.

3. Kasigwa Company Ltd uses the Miller-Orr model to manage its cash balance. The
following data is available:
i) Fixed transaction cost is TZS 50,000
ii) Daily variance of cash flows is TZS 1,000,000
iii) Daily interest rate is 1%
Calculate:
a) The spread
b) The upper limit if the lower limit (LLL) is set at TZS5,000
c) The target cash balance (ZZZ)

4. Given the following:

i) Lower Limit = TZS 4,000
ii) Spread = TZS 600
iii) Current Cash Balance = TZS5,500
Determine:
a) Whether any action is required.
b) If so, how much cash should be transferred, and in which direction?

5. The maximum cash required for GVM Wajenzi over the year is TZS 200 million in cash.
GVM incurs a TZS 5,000 transaction cost per conversion and the annual interest rate is
5%. Determine their optimal cash balance.

6. A company reports the following information for the year:

i) Net Credit Sales is TZS600,000
ii) Average Accounts Receivable is TZS50,000
Calculate the Accounts Receivable Turnover Ratio and interpret the result.
7. A company estimates the following for a product:
i) Annual demand (D) 10,000 units
ii) Ordering cost per order (S): TZS50
iii) Holding cost per unit per year (H): TZS2

Calculate:
a) The Economic Order Quantity (EOQ)
b) The total number of orders per year
c) The total annual inventory cost