MODULE 5

• Working capital


  The amount of current assets (financial management view) or current assets net of current liabilities (accounting view) used to finance the firm's short term operations
• Temporary current assets


  Current assets required to support fluctuations of the firm's level of activity (volume of operations)
• Permanent current assets


  Current assets required to maintain normal operations
• Working Capital Management (WCM)

  The efficient and effective utilization of working capital to attain organizational objectives related to: Profitability of operations, Liquidity of financial resources, Minimization of risks & company costs
• WCM involves managing


  • The company's investment in current assets (cash, MS, receivables, inventories)
  • The company's use of current liabilities (level & mix of short term financing)
• Working capital policy refers to the basic decisions regarding

  • Target levels for each category of current assets
  • How current assets will be financed
• Relaxed Current Investment Policy


  Carries a relatively large amount of current assets. Sales is stimulated by liberated credit policy resulting to high level of receivables. The firm carries a large amount of inventory
• Restricted Current Investment Policy


  Current assets are minimized. The firm implements tight credit policy though it means running the risk of losing sales, holds minimal safety stock of cash and inventory, and works out the highest current asset turnover
• Moderate Current Investment Policy

  Policy between relaxed & restricted
• Conservative Financing Policy


  Almost all investment assets are financed by long term debts, resulting to lesser amounts of short term debts. It reduces liquidity risk but also reduces profit due to greater financing costs
• Aggressive Financing Policy


  Uses short term debts to finance, not only temporary but also part or all of the permanent current asset requirements. Thus, leading to greater amounts of short terms debts & lesser amount of long term debts. It increases profits due to lesser financing costs of short term debts but also exposes the firm to liquidity risks due to low working capital position
• Maturity Matching Policy (Hedging Principle/Self-liquidating debt Principle)


  Matches the maturities of obligations to the income (cash flow) generating characteristics of the assets financed. Long term debts are used to finance long term assets (permanent working capital) requirements while short term debts to finance short term assets
• Balanced Policy


  Balances the trade-off between risk and profitability in a manner consistent with its attitude toward bearing risk
• Financing Requirements


  • Permanent - property, plant & equipment (fixed assets) and permanent current assets that must always be with the company throughout the year
  • Seasonal (temporary) - additional requirements arising from fluctuation in the volume of activity (production & sales) arising from seasonal changes in demand level for products during the year
• Financing Comparisons


  • Short term Financing (Current Liability - CL): Flexibility of use, Greater liquidity risk, Generally lower interest rate, More unstable interest rate fluctuations
  • Long term Financing (Non Current Liability - NC): Less flexibility, Lesser liquidity risk, Generally higher interest rate, Fixed interest rate during the fixed period
• Minimizing working Capital Requirements involves: Efficiency cash, receivable & raw materials management, Reduction of time lag between completion & shipment of finished goods, Obtaining favourable credit terms from suppliers
• Reasons (Motivations) for Holding Cash

  • Transactional motive - to facilitate normal transactions of the business
  • Contractual motive - to meet bank (creditor) requirements contained in a financing agreement
  • Precautionary motive (safety stock) - to provide buffer against contingencies
  • Speculative motive - to take advantage of special income opportunities
• Cash Management Strategies


  • Managing (Accelerating) Collections - reducing the period between the time customers pay their bills & time the cash is reflected in company's balances, ready for disturbances
  • Controlling Disbursements - control of cash payments which depends on the ability to defer cash payments to the maximum feasible time, play the float, use a remote disbursement account, use Zero Balance Accounts (ZBA), less frequent payroll and schedule issuance of checks to suppliers
  • Synchronize inflows and outflows - arranging things so that cash inflows will coincide with cash outflows
  • Reduce the need for precautionary balance (safety stock) by increasing forecast accuracy, negotiating a line of credit, holding marketable securities
• Cash Flow Management


  1. Preparation of a cash budget - projection of the timing & amount of cash inflows & outflows

  2. Optimizing Cash Balances - knowing the appropriate level of cash to be maintained relative to MS
• Baumol Model


  An inventory management (EOQ type) model developed by William J. Baumol which determines the optimal cash balance as the level where cost of holding cash is minimum
• Probabilistic Model (Control Limit Model)


  Developed by Mirton Miller & Daniel Orr which determines the optimal cash balance as the optimal return point for security transaction
• Managerial Problems related to Cash Management include: Forecasting and monitoring cash flows and balances must be made for relatively short period of time, therefore the need for patterns of cash movements
• Forecasting and monitoring cash flows and balances must be made for relatively short period of time
• The need for patterns of cash movements (as revealed by regular reports of actual receipts & disbursements, statistics of average daily or weekly collections, average interest rates on MS, and average age of A/R and A/P
• Effective control system for cash is needed to avoid misappropriation and handling losses
• Marketable Securities (MS)


  Short term money market instruments that can easily be converted to cash
• Most popular MS


  • Government securities
  • Commercial papers
  • Certificate of time deposits in commercial banks
• Treasury bills


  Issued by BS & represents obligations of the national government
• Central bank bills (CB certificates of indebtedness)

  Represents indebtedness of BSP
• Commercial papers


  Short term unsecured promissory note issued by corporations w/ very high credit standing. It is usually issued based on approval SEC.
• Reasons for Holding MS

  • To serve as substitute for cash balances
  • To serve as temporary investment
  • To meet financial requirements
• Liquidity (marketability) of MS


  Saleability of the MS on short notice and at its approximate market value, in case of need for cash
• Default risk


  The probability that the borrower will be unable to pay interest and/or principal when they become due
• Guidelines to minimize default risk

  • Accreditation - placement of excess funds only to "acceptable institutions"
  • Single borrower's limit - established to avoid over exposure with any single financial institution
  • Preference for high grade commercial paper and government securities as instruments
  • Maintaining a list of acceptable collaterals in case of repurchase agreement
• Settlement risk


  The probability that the intermediaries, not the issuer, will default
• Settlement risk examples


  • Loss of T-Bills kept in the custody of a bank that market the T-Bills
  • Stockbroker can't deliver the investment documents, for one reason or another
• Interest rate risk


  Arises from the volatility of interest rates
• Interest rate risk types

  • Price risk - decline in the market value of investments
  • Inflation risk - inflation will erode the purchasing power of money
• Financial manager should balance the risk and return of MS
• Maturity dates of MS held should coincide, when possible, with the date at which the firm needs cash, or when the firm will no longer have cash to invest