INSTRUCTOR’S MANUAL

CHAPTER
Cash and Working
5 Capital Management

Learning Objectives
• Explain working capital and the cash conversion cycle
• Describe motives for holding cash
• Describe and analyse the different mechanisms for managing the firm’s cash collection and
disbursement procedures
• Identify and compute inventory management costs
• Apply inventory management models to optimize the fi rm’s inventory
• Explain the reasons for granting credit
• Evaluate credit granting decisions
• Describe important accounts receivable management tools
• Describe the mechanics of different types of short-term borrowings and evaluate their costs

Key Teaching Points

INTRODUCTION
• A firm’s working capital is made up of its current assets minus its current liabilities.
• Current assets comprise of inventories, accounts receivables, cash and short-term securities,
whereas current liabilities comprise of accounts payable, accruals, short-term borrowings and taxes
payable.
• Net working capital is the difference between the current assets and current liabilities.
• Working capital management (WCM) involves all aspects of the administration of current assets
and current liabilities It involves making the appropriate and suitable investments in inventories,
accounts receivables, cash and marketable securities, as well as the mix of short-term financing.
• WCM covers several basic relationships:
(a) Sales impact
(b) Liquidity
(c) Relations with stakeholders

GUIDING PRINCIPLES ABOUT WORKING CAPITAL FINANCE

• Firms must maintain sufficient levels of liquidity within each of the firms. Simultaneously, it seeks
to operate as efficiently, effectively and economically as possible to maximize its profits
• Hence, there exists trade-offs between risks and returns when making decisions about WCM i.e.
firm profitability versus firm liquidity.
• This is illustrated in Table 5.1 on page 102
 Instructor’s Manual
2

FINANCING WORKING CAPITAL

• Methods for financing working capital:
(a) Maturity-matching approach
(b) Conservative approach
(c) Aggressive approach
• Under maturity-matching approach, firms hedge against working capital risks by matching the
maturities of assets and liabilities.
• Conservative approach to financing working capital uses more long term and less short term
financing. This attempts to avoid credit-related risk.
• Aggressive approach uses less long term and more short term financing. The objective is to raise
profitability of the firm

CASH MANAGEMENT CYCLE

• Cash conversion cycle is the length of time between the payment of creditors and receipt of cash
from debtors.
• Cash conversion cycle = [Inventory conversion period] + [Debtors collection period] – [Payables
credit period]
• Inventory conversion period is the average time between purchasing stocks and selling the goods
• Debtors’ collection period is the number of days for debtors to pay from time of sale
• Creditors’ credit period is the number of days from time of purchase of materials and labour for
goods and the time of payment
• A cash budget represents a detailed plan of a firm’s future cash flows, in terms of cash inflows and
outflows.
• Cash budgets may be used to decide whether and how much credit to extend to the firm’s
customers.
• There are three main components for preparing a cash budget:
(a) Time period
(b) Desired cash position
(c) Estimated sales and expenses
• Reasons (motives) for holding cash:
(a) Transactions
(b) Precautionary
(c) Speculative
• Transaction demand models that may be used to evaluate the demand for funds in a firm:
(a) Baumol model
(b) Miller-Orr cash model
• The optimum amount of cash that ought to be held by a firm depends on
(a) forecasts of the future cash inflows and outflows of the firm;
(b) efficiency with which the cash flows of the firm are managed;
(c) availability of liquid assets to the firm and the extent of liquidity risks it faces;
(d) borrowing capability and capacity of the firm;
(e) company’s tolerance of risk
• Surplus cash should be invested to earn a return by being invested on a short-term basis.

INVENTORY MANAGEMENT
• Holding stocks is important for firms as it acts a buffer in ensuring that production-marketing
process can carry and not be affected by stockouts.
• Inventory management ensures that firms have sufficient inventory for production and for sale to
customers
 Cash and Working Capital Management
3

• Stocks are made up of:

(a) Raw materials
(b) Work in progress
(c) Finished goods
• Economic order quantity – model to address the inventory quantity problem that involves optimal
order size given its expected usage, carrying costs and ordering costs. It seeks to determine the
order size that would minimize total inventory costs.
• To avoid problems faced by a firm arising from stockouts, firms hold safety stocks as a precautionary
measure.
• The lowest level of inventory is determined such that it represents that point that stock levels are
allowed to drop to before new orders are made for stocks – reorder point.
• Reorder point is influenced by:
(a) Lead time for stocks to be delivered
(b) Safety stock level desired

DEBTORS
• Sales conducted on credit terms offered to customers (instead of cash terms) leads to the creation
of accounts receivables (debtors).
• Size of investment in accounts receivables is determined by: a) Level of sales b) Credit and collection
policies of the firm
• Credit terms are conditions contained in agreements between a firm and its customers, pertaining
to the credit granted by the former to the latter.
• Credit standards relates to the criteria used to assess a customer and determine whether to grant
credit, plus the extent of the credit period and credit limit.
• Credit information is required to analyse the creditworthiness of its customers, sources of which
may be from internal and external sources.
• Two basic approaches to evaluate a credit application:
(a) Judgemental approach – uses credit information, specific knowledge and past experience
(b) Objective approach – uses scientific approach towards evaluating creditworthiness
• Judgemental approach may use the traditional five C’s credit: character, capacity, capital, collateral
and condition.
• Credit scoring involves numerical evaluation of each customer, using scientific approaches. The
higher the total score derived from the model, the greater the credit amount and the longer the
credit period allowed.
• Other factors to consider before deciding on the credit terms:
(a) Order size and frequency
(b) Market position
(c) Profitability
(d) Financial resources of the respective businesses
(e) Industry norms
(f) Business objectives
• Steps available to a firm when dealing with delinquent accounts:
(a) Letter or statement of account
(b) Telephone call
(c) Personal visits to customers’ premises
(d) Collection agencies
(e) Legal proceedings
• Credit policy changes adopted by a firm towards its credit customers involve altering the terms,
standards or collection practices. Examples of credit policy changes are extending credit periods
and Offer of settlement discounts.
 Instructor’s Manual
4

• Any decision to change the firm’s credit policy should only be made after considering the trade-
offs between costs and benefits of changing the credit policy
• Firms may use accounts receivable balances (debtors) as collateral to raise finances for working
capital purposes, for e.g. factoring.
• Factoring may be broken down into ‘with’ recourse and ‘without’ recourse types.
• Non-recourse factoring is where the factoring company purchases the debts without recourse to
the firm selling its accounts receivable. This means that if the firm’s debtors do not pay what they
owe, the factor will not ask for his money back from the client.
• Recourse factoring is where the business takes the bad debt risk.

MARKETABLE SECURITIES
• Marketable securities in Malaysia include:
(a) Government debt securities – Malaysian Government Securities (MGS), Malaysian
Treasury Bills (MTB), Government Investment Issues (GII) and Malaysian Islamic
Treasury Bills (MITB)
(b) Repurchase Agreements (Repo)
(c) Negotiable Certificate of Deposits (NCDs)
(d) Banker’s acceptances (BA)
(e) Commercial paper (CP)

TRADE CREDITORS
• Trade creditors represent another source of short term finance for a firm, with payment to the
trade creditors made at a later period.
• Decisions surrounding management of trade creditors include:
(a) Costs of foregoing early discounts
(b) Effective use of trade credit
• Cost of foregoing early discounts can be estimated by determining:
(a) Annual percentage rate (APR)
(b) Annual percentage yield (APY)

OTHER FORMS OF SHORT-TERM FINANCING

• Banks also provide short term financing, known as line of credit.
• Line of credit is a credit facility that allows a borrower to take advances, during a defined period,
up to the preset “line limit” and repay the advances at the borrower’s discretion (with the exception
that the entire principal balance plus accrued interest is due on the maturity date).
• Short term credit facilities from banks include bank overdrafts, trust receipts, bankers’ acceptances
and letters of credit
• Bank overdraft represents a standby cash flow to cover a firm’s daily working requirement.
• Trust receipt is used to finance purchases and importation of goods. Firms can draw on the trust
receipt, being funds released by bank to suppliers for the goods purchased.
• Banker’s acceptance is a usuance bill of exchange drawn by a firm to its order and accepted by the
bank, and is payable on a specified date.
• Letter of credit represents an undertaking by the bank, acting as agreed with the firm, that the bank
shall pay an agreed amount to the recipient against presentation of stipulated documents and in
full compliance of the terms and conditions of the credit.
• Different types of LCs available include:
(a) irrevocable LCs
(b) standby LCs
(c) revolving LCs
 Cash and Working Capital Management
5

(d) transferable LCs

(e) assignments of proceeds under an LC
(f) back-to-back LCs

TERM LOANS
• Term loans from banks represent intermediate term debt, with terms exceeding five years. It carries
fixed monthly repayments and interest is pegged to BLR.

OVERTRADING
• Overtrading (or undercapitalisation) occurs when a firm experiences a situation where it is trying
to support a too large volume of trade with a too small working capital base.
• The supply of funds fails to meet the demand for funds within the firm
• Indications that a firm may be overtrading include:
(a) Rapid growth in sales over a relatively short period
(b) Rapid growth in the amount of current assets, and perhaps fixed assets
(c) Deteriorating stock days and debtor days’ ratios
(d) Increasing use of trade credit to finance current asset growth (increasing creditor days)
(e) Declining liquidity, indicated perhaps by a falling quick ratio
(f) Declining profitability, perhaps due to using discounts to increase sales
(g) Decreasing amounts of cash and liquid investments, or a rapidly increasing overdraft