6. Management of Working Capital - Cash

What are the reasons for holding cash?

• Transactions motive

• Precautionary motive

• Speculative motive

What are some methods of dealing with cash shortages?

• Reduce inventories

• Defer capital expenditure

• Defer or reduce dividends

• Chase receivables to pay earlier

• Postpone the payment of payables

• Use short-term borrowing (overdraft)

• Sell surplus assets

• Sale and leaseback

When may a cash surplus arise?

A cash surplus may arise over the short term, medium term & long term

What are some short-term uses of surplus cash?

• Reduce overdraft

• Invests in short-term Treasury Stock

• Invest in bank deposit account

• Invest in “blue-chip” shares

What are some long-term uses of surplus cash?

• Invest in new projects

• Acquire other companies

• Increase dividends

• Buy back shares

• Repay long-term loans

What is a cash budget?

The most important tool, in practice, for the management of any company’s cash position

Why is the cash budget vital?

Vital to identifying in advance a likely deficit or surplus, so that appropriate action can be taken to avoid any problem or profit any opportunity

What to do with cash budget is negative?

• Curtail activities

• Explore other sources of cash

  • Long term loan to finance capital expenditure

  • Factoring arrangement to provide cash due from accounts receivables quicker

• Make efforts to increase debt collection period

• Delay payments to accounts payable

• Postpone dividend payments

  • ! Damaging if a large company

• Persuade staff to work at a lower rate in return for:

  • Annual bonus

  • Profit-sharing agreement

• Take on extra staff to reduce overtime paid

• Review stock-holding policy

  • It may be possible to meet demand from current production and minimise cash tied up in inventories

What is the Baumol model?

• Answers how much cash to transfer from interest-earning cash accounts

• Considers the fee payable to sell investments on transfer

• Not sensible to transfer entire amount immediately as would lose interest for the whole year

What is the Economic quantity of cash formula?

Square root of:

(2 x Annual cash required x Cost of ordering cash)/(Net interest cost of holding cash)

What is the Miller Orr model?

Manages to achieve a reasonable degree of realism without being too elaborate

• In practice, cash flows are likely to fluctuate considerably from day-to-day

• There is also a likelihood that the balances are likely to “wonder” upwards or downwards over a period

What are the basic steps of the Miller Orr model?

1. A safety level or lower limit of cash is decided upon

2. A statistical calculation is made based on the variations of the cash flows, in order to agree on allowable range of fluctuations

3. Using this calculated range, an upper limit of cash is fixed

4. The cash balance is managed, to ensure that the balance is always kept between the upper & lower limits

What is the formula of the Miller Orr model?

Upper limit = lower limit + spread

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

Spread =

3x(3/4 x transaction cost x variation of cash flows) / Interest rate)^1/3