Working Capital Management

WORKING CAPITAL MANAGEMENT, ACCA
4. Working Capital Management

1. Introduction
• Working capital management is the management of the short-term investment and financing of a
company.
- Cash and cash equivalents, inventory, accounts receivable, accounts payable, short-term
loans, etc.
• Goals:
- Adequate cash flow for operations - Liquidity
- Most productive use of resources – Profitability
Note: Too much cash may result in the company putting too much investment in low and non-
earning assets.
Internal and External Factors that Affect Working Capital Needs
Internal Factors External Factors
• Company size and growth rates • Banking services

• Organizational structure • Interest rates
• Sophistication of working capital • New technologies and new products
management • The economy
• Borrowing and investing • Competitors
positions/activities/capacities
2. Managing and measuring Liquidity

• Liquidity is the ability of the company to satisfy its short-term obligations using assets that are
readily converted into cash.
• Liquidity management is the ability of the company to generate cash when and where needed.
• Liquidity management requires addressing drags and pulls on liquidity.
- Drags on liquidity are forces that delay the collection of cash, such as slow payments by
customers and obsolete inventory.
- Pulls on liquidity are decisions that result in paying cash too soon, such as paying trade
credit early or a bank reducing a line of credit.
Sources of liquidity
• Primary sources of liquidity
- Ready cash balances (cash and cash equivalents)
- Short-term funds (short-term financing, such as trade credit and bank loans)
- Cash flow management (for example, getting customers’ payments deposited quickly)
• Secondary sources of liquidity
- Renegotiating debt contracts
- Selling assets
- Filing for bankruptcy protection and reorganizing.
Measure of Liquidity
LIQUIDITY RATIOS
Current assets Ability to satisfy current liabilities

Current ratio = using current assets
Current liabilities
NOTES COMPILATION FOR PRIVATE CIRCULATION 4.1
Short-term Ability to satisfy current liabilities

Cash + + Receivables
Quick ratio = investments using the most liquid of current
Current liabilities assets
RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS
Credit Sales How many times accounts receivable

Receivables turnover = are created and collected during the
Average receivables
period
Receivables Days In how many days accounts

Average Receivables*365 365 receivable are converted in to cash.
=
Credit Sales Receivables Turnover
Inventory turnover =
Cost of sales How many times inventory is created
Average inventory and sold during the period
Average Inventory*365 365 In how many days finished goods are
Inventory Days =
Cost of Sales Inventory Turnover converted in to receivables (sales).
Raw materials Days In how many days raw materials are

Average Raw Materials Inventory*365 begun processing.
=
Annual Purchases
Average WIP*365 In how many days WIP gets ready as
WIP Days (period) =
Cost of Production/ Cost of Sales finished goods.
Accounts payable Average time it takes to pay its

Number of days of payables = = suppliers
Average day's
purchases
365
Accounts payables turnover
Example 1
a) The current ratio of BM Ltd. Is 2:1. While quick ratio is 1.80:1. If the current liabilities are $40,000,
what will be the value of Inventory?
Hints: $ 8,000
b) The average period of credit allowed by a company which has an annual credit sales of $120 million is
one month. By reducing the period of credit to half-a-month, sales fall to $ 108 million. Find the fall in
average amount of debtors.
Hints: $550,000
c) The budgeted annual sales of a firm is $ 80 million and 25% of the same is cash sales. If the average
amount of debtors of the firm is $ 5 million, find the average collection period of credit sales.
Hints: Collection period = 5 / 60 year or 1 month.
d) The average period of credit allowed by a company to its customers last year was one month and the
average amount of debtors was $ 10 million. To increase sales and profitability the company doubled the
period of credit during the current year. As a result the average amount of debtors increased to $ 25
million. If the company has a contribution / sales ratio of 40%; what additional contribution has been
earned by the company during the current year?
Hints: Increase in contribution = $12 million
e) WW Co has current ratio of 2 considering current assets comprised of receivables and inventory only.
Receivables are $3 million and current liabilities are $2 million. What are inventory days is cost of sales
is $10 million per annum? Hints: 36.5 days
Example 2:Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2.
The company is now adopting a new inventory system. If the new system is able to reduce the firm’s
inventory level and increase the firm’s inventory turnover ratio to 5, while maintaining the same level of
sales, how much cash will be freed up? Hints: $3,000,000
Example 3: Medwig Corporation has a DSO of 17 days. The company averages $3,500 in credit sales
each day. What is the company’s average accounts receivable? Hints: A/R = $59,500
Example 4: A chain of appliance stores, APP Corporation, purchases inventory with a net price of
$500,000 each day. The company purchases the inventory under the credit terms of 2/15, net 40. APP
always takes the discount, but takes the full 15 days to pay its bills. What is the average accounts payable
for APP? Hints: $7,500,000
Example 5: McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500.
Forty percent of the customers pay on the 10th day and take discounts; the other 60 percent pay, on
average, 40 days after their purchases. [Consider 365 days a year]
a. What is the days sales outstanding?
b. What is the average amount of receivables?
c. What would happen to average receivables if McDowell toughened up on its collection policy with the
result that all non-discount customers paid on the 30th day?
Hints: a. DSO = 28 days; b. A/R = $70,000. c. 30 days; $75,000
Operating and Cash Conversion Cycles

• The operating cycle is the length of time it takes a company’s investment in inventory to be
collected in cash from customers.
• The net operating cycle (or the cash conversion cycle) is the length of time it takes for a
company’s investment in inventory to generate cash, considering that some or all of the inventory
is purchased using credit.
• The length of the company’s operating and cash conversion cycles is a factor that determines how
much liquidity a company needs.
- The longer the cycle, the greater the company’s need for liquidity.
Collect on Acquire Acquire

Accounts Inventory for Pay Suppliers Inventory for
Receivable Cash Credit
Collect on
Sell Inventory
Accounts
for Credit
Receivable
Sell Inventory for
Credit
Operating Cycle Cash Conversion Cycle
• The cycle indicates the length of time that cash is invested in current assets (other than cash).
• The cash conversion cycle is useful when the company acquires inventory using trade credit.
• The length of time associated with a segment in the cycle varies among companies and industries.
Operating and Cash Conversion Cycles: Formulas

Number of days Number of days
Operating cycle = +
of inventory of receivables
Net operating cycle Number of days Number of days Number of days

or = + -
Cash conversion cycle of inventory of receivables of payables
Example 6: The Zocco Corporation has an inventory conversion period of 75 days, a receivables
collection period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the firm’s cash conversion cycle?
b. If Zocco’s annual sales are $ 3,421,875 and all sales are on credit, what is the firm’s investment in
accounts receivable?
c. How many times per year does Zocco turn over its inventory?
Hints: a. 83 days; b. $356,250; c. 4.87 times
Example 7: The table below gives information extracted from the annual financial statements of
Management plc for the past year.
Management plc - Extracts from annual accounts
Inventories: raw materials $108,000
Work in progress $75,600
Finished goods $ 86,400
Purchases of raw materials $518,400
Cost of production $675,000
Cost of goods sold $756,000
Sales $864,000
Receivables $172,800
Payables $ 86,400
Calculate the length of the working capital cycle (assuming 365 days in the year).
Hints: Receivable Days = 73; Inventory Days = 42; WIP Days = 41; Raw Materials Days = 76; WCC=
232 days; Payable days = 61; Net Operating cycle = 171 days
Example 8: The Christie Corporation is trying to determine the effect of its inventory turnover ratio and
days sales outstanding (DSO) on its cash flow cycle. Christie’s 2001 sales (all on credit) were $150,000
and it earned a net profit of 6 percent, or $9,000. It turned over its inventory 5 times during the year, and
its DSO was 36.5 days. The firm had fixed assets totaling $35,000. Christie’s payables deferral period is
40 days.
a. Calculate Christie’s cash conversion cycle.
b. Suppose Christie’s managers believe that the inventory turnover can be raised to 7.3 times. What would
Christie’s cash conversion cycle for 2001?
Hints: a. 69.5 days; b (1) 46.5 days
Over-capitalization and Working Capital

Overinvestment in current assets i.e. cash, inventories and receivables and very few payables.
Indicators of Over-capitalization
Sales/working capital Compare with previous years or similar companies. A low or falling ratio
may indicate over-capitalization.
Liquidity ratios Compare with previous years or similar companies.
Turnover periods Long turnover periods for inventory and accounts receivable or short credit
period from suppliers may be unnecessary. Working capital requirements
can be reduced by improving these turnover times.
Overtrading
In contrast with over-capitalization, overtrading happens when a business tries to do too much too quickly
with too little long-term capital, so that it is trying to support too large a volume of trade with the capital
resources at its disposal.
Even if an overtrading business operates at a profit, it could easily run into serious trouble because it is
short of cash.
Symptoms of overtrading are as follows.
a. There is a rapid increase in sales revenue.
b. There is a rapid increase in the volume of current assets and possibly also non-current assets.
Inventory turnover and accounts receivable turnover might slow down.
c. There is only a small increase in equity capital (perhaps through retained profits). Most of the
increase in assets is financed by credit, especially Trade accounts payable; a bank overdraft,
d. The proportion of total assets financed by proprietors' capital falls, and the proportion financed
by credit rises.
e. The current ratio and the quick ratio fall.
f. The business might have a liquid deficit; that is, an excess of current liabilities over current
assets.
3. Managing Inventory
• The objective of managing inventory is to determine and maintain the level of inventory that is
sufficient to meet demand, but not more than necessary.
• Motives for holding inventory:
- Transaction motive: To hold enough inventory for the ordinary production-to-sales
cycle.
- Precautionary motive: To avoid stock-out losses.
- Speculative motive: To ensure availability and pricing of inventory.
• Approaches to managing levels of inventory:
- Economic order quantity: Reorder point—the point when the company orders more
inventory, minimizing the sum of order costs and carrying costs.
- Just in time (JIT): Order only when needed, when inventory falls below a specific level
- Materials or manufacturing resource planning (MRP): Coordinates production planning
and inventory management.
Bottom line: The appropriateness of an inventory management system depends on the costs and benefits
of holding inventory and the predictability of sales.
Evaluating Inventory Management

• Measures
- Inventory turnover ratio.
- Number of days of inventory
• When comparing turnover and number of days of inventory among companies, the analyst should
consider the different product mixes among companies.
Economic Order Quantity

 An economic order quantity can be calculated as a guide to minimizing costs in managing
inventory levels.
 However, bulk discounts can mean that a different order quantity minimizes inventory costs.
 Uncertainty in the demand for inventories and/or the supply lead time may lead a company to
decide to hold buffer inventories in order to reduce or eliminate the risk of 'stock-outs' (running
out of inventory).
INVENTORY COSTS
Holding costs The cost of capital
Warehousing and handling costs
Deterioration
Obsolescence
Insurance
Pilferage
Procuring costs Ordering costs
Delivery costs
Shortage costs Contribution from lost sales
Extra cost of emergency inventory
Cost of lost production and sales in a stock-out
Purchase cost of inventory Relevant particularly when calculating discounts for bulk
quantity purchases
The economic order quantity (EOQ) is the optimal ordering quantity for an item of inventory which
will minimize costs.
Let D = usage in units for one period (the demand)
Co = cost of placing one order
Ch = holding cost per unit of inventory for one period relevant costs only
Q = re-order quantity (EOQ)
Relevant cost = (holding cost per unit × average inventory) + ordering costs
Holding Costs = Q x Ch /2
Ordering Cost = Co x D/ Q
The objective is to minimize T = Q x Ch /2 + Co x D/ Q
T will be minimum when ordering cost is equal to holding cost i.e.
EOQ √2Co /Ch
Uncertainties in demand and lead times: a re-order level system

Re-order level = maximum usage x maximum lead time.
The average annual cost of such a safety inventory would be:

Quantity of safety inventory (in units) x Inventory holding cost per unit per annum
Maximum inventory level = re-order level + re-order quantity – (minimum usage x minimum lead time)
Minimum inventory or buffer safety inventory = re-order level – (average usage x average lead time)
Average inventory = buffer safety inventory + re-order amount/2
Example 9: A company has an inventory management policy which involves ordering 50,000 units when
the inventory level falls to 15,000 units. Forecast demand to meet production requirements during the
next year is 310,000 units. You should assume a 50-week year and that demand is constant throughout the
year. Orders are received two weeks after being placed with the supplier. What is the average inventory
level? Hints: Avg. Inventory = 27,600 units
Example 10: The annual demand for an item of inventory is 125 units. The item costs $200 a unit to
purchase, the holding cost for one unit for one year is 15% of the unit cost and ordering costs are $300 an
order. The supplier offers a 3% discount for orders of 60 units or more, and a discount of 5% for orders of
90 units or more. What is the cost-minimizing order size?
Hints: EOQ = 50 units; Annual Costs = $26,500 at EOQ; Annual Cost = $25,748 at discount of 3%;
Annual cost = $25,449.2 at 5% discount
Example 11: Janis has demand for 40,000 desks p.a. the purchase price of each desk is $25. There are
ordering costs of $20 for each order placed. Inventory holding costs amount to 10% p.a. of inventory
value.
Calculate the inventory costs p.a. for the following order quantities, and plot them on a graph:
(a) 500 units (b) 750 units (c) 1000 units (d) 1250 units
Hints: 750 units
Example 12: For the information given in Example 11,

(a) Use the EOQ formula to calculate the Economic Order Quantity.
(b) Calculate the total inventory costs for this order quantity.
Hints: (a) 800 units; (b) $2000
Example 13: For the information given in Example 11 the supplier now offers us discounts on purchase
price as follows:
Order quantity discount
0 to < 5,000 0%
5,000 to < 10,000 1%
10,000 or over 1.5 %
Calculate the Economic Order Quantity.
Hints: 5,000 units
Example 14: Economic Order Quantity. Luster Corporation presents the following data: Usage is 400
units per month, cost per order is Rs.20, and carrying cost per unit is Rs.6. Given these data, answer the
following questions: (a) What is the economic order quantity for the month? (b) How many orders are
required each month? (c) How often should each order be placed?
Hints: (a) EOQ =52; (b) 8; (c) every 4 days
Example 15: Stockout Cost. Boston Corporation uses 30,000 units. Each order placed is for 1,500 units.
The stock out units is 300. Management is willing to accept a stock out probability of 40 percent. The
stock out cost per unit is Rs.3.20. What is the total stock out cost?
Hints: Stock out cost = Rs.7,680
Stock out cost = Number of orders * stock out units * unit stock out cost * probability
Example 16: Optimum Inventory Level. Saft Corporation is considering changing its inventory policy.
At present, the inventory turns over 12 times per year. Variable costs are 60 percent sales. The rate of
return is 21 percent. Sales and inventory turnover data follow:
Sales (Rs.) Turnover
800,000 12
870,000 10
950,000 7
1,200,000 5
Determine the inventory level that results in the greatest net savings.
Hints: The inventory level that results in the greatest net savings is Rs. 240,000.
4. Managing Accounts Receivable

Giving credit has a cost:
 the value of the interest charged on an overdraft to fund the period of credit, or
 the interest lost on the cash not received and deposited in the bank.
An increase in profit from extra sales resulting from offering credit could offset this cost.
Credit is offered to customers to win sales and sales mean profits. But there is a cost to giving credit.
The benefits should exceed the costs.
Example 17: Zygo Company sells widgets for $1,000, which enables it to earn a profit, after all other
expenses except interest, of $100 (ie a 10% margin).
(a) Aibee buys a widget for $1,000 on 1 January 20X1, but does not pay until 31 December 20X1.
Zygo relies on overdraft finance, which costs it 10% pa. What is the effect on profit?
(b) If Aibee had paid after six months, the effect would be the effect on profit?
Hints: (a) Nil (b) $50
Objectives in managing accounts receivable:

- Process and maintain records efficiently.
- Control accuracy and security of accounts receivable records.
- Collect on accounts and coordinate with treasury management.
- Coordinate and communicate with credit managers.
- Prepare performance measurement reports.
• Companies may use a captive finance subsidiary to centralize the accounts receivable functions
and provide financing for the company’s sales.
Evaluating the Credit function

• Consider the terms of credit given to customers:
- Ordinary: Net days or, if a discount for paying within a period, discount/discount period,
net days (for example, 2/10, net 30).
- Cash before delivery (CBD): Payment before delivery is scheduled.
- Cash on delivery (COD): Payment made at the time of delivery.
- Bill-to-bill: Prior bill must be paid before next delivery.
- Monthly billing: Similar to ordinary, but the net days are the end of the month.
• Consider the method of credit evaluation that the company uses:
- Companies may use a credit-scoring model to make decisions of whether to extend credit,
based on characteristics of the customer and prior experience with extending credit to the
customer.
Credit control policy

Several factors should be considered by management when a policy for credit control is formulated.
These include:
a) The administrative costs of debt collection
b) The procedures for controlling credit to individual customers and for debt collection
c) The amount of extra capital required to finance an extension of total credit – this cost might be
bank overdraft interest, or the cost of long-term funds (such as loan inventory or equity)
d) Any savings or additional expenses in operating the credit policy
e) The ways in which the credit policy could be implemented – for example:
a. Credit could be eased by giving accounts receivable a longer period in which to settle
their accounts
b. A discount could be offered for early payment
f) The effects of easing credit, which might be to encourage a higher proportion of bad debts, and an
increase in sales volume.
Provided that the extra gross contribution from the increase in sales exceeds the increase in fixed
cost expenses, bad debts, discounts and the finance cost of an increase in working capital, a
policy to relax credit terms would be profitable.
To determine whether it would be profitable to extend the level of total credit, it is necessary to assess:
 The extra sales that a more generous credit policy would stimulate
 The profitability of the extra sales
 The extra length of the average debt collection period
 The required rate of return on the investment in additional accounts receivable
Example 18: Russian Beard Co is considering a change of credit policy which will result in an increase in
the average collection period from one to two months. The relaxation in credit is expected to produce an
increase in sales in each year amounting to 25% of the current sales volume.
Selling price per unit $10
Variable cost per unit $8.50
Current annual sales $2,400,000
The required rate of return on investments is 20%. Assume that the 25% increase in sales would result in
additional inventories of $100,000 and additional accounts payable of $20,000.
Advise the company on whether or not to extend the credit period offered to customers, if:
(a) All customers take the longer credit of two months
(b) Existing customers do not change their payment habits, and only new customers take a full two
months' credit.
Hints: ROI on additional investment (a) ROI 23.7%, Benefits $14,000; (b) ROI 50%, Benefit Rs.
54,000. New credit policy worthy in both cases.
Example 19: Enticement Co currently expects sales of $50,000 a month. Variable costs of sales are
$40,000 a month (all payable in the month of sale). It is estimated that if the credit period allowed to
accounts receivable were to be increased from 30 days to 60 days, sales volume would increase by 20%.
All customers would be expected to take advantage of the extended credit. If the cost of capital is 12.5% a
year, is the extension of the credit period justifiable in financial terms?
Hints: Annual net benefit = $ 15,250
Assessing creditworthiness
In managing accounts receivable, the creditworthiness of customers needs to be assessed. The risks and
costs of a customer defaulting will need to be balanced against the profitability of the business provided
by that customer.
(a) New customers should give two good references, including one from a bank, before being granted
credit.
(b) Credit ratings might be checked through a credit rating/reference agency.
(c) A new customer's credit limit should be fixed at a low level and only increased if their payment
record subsequently warrants it.
(d) For large value customers, a file should be maintained of any available financial information
about the customer. This file should be reviewed regularly. Information is available from the
company's annual report and accounts.
(e) Government departments can sometimes advise on overseas companies.
(f) Press comments may give information about what a company is currently doing.
(g) The company could send a member of staff to visit the company concerned, to get a first-hand
impression of the company and its prospects. This would be advisable in the case of a prospective
major customer.
Early settlement discounts

Early settlement discounts may be employed to shorten average credit periods and to reduce the
investment in accounts receivable and therefore interest costs of the finance invested in trade receivables.
Example 20: Lowe and Price Co has annual credit sales of $12,000,000, and three months are allowed for
payment. The company decides to offer a 2% discount for payments made within 10 days of the invoice
being sent, and to reduce the maximum time allowed for payment to two months. It is estimated that 50%
of customers will take the discount.
If the company requires a 20% return on investments, what will be the effect of the discount? Assume that
the volume of sales will be unaffected by the discount.
Hints: Net benefit of discount offer = $246,667
Example 21: A company has sales of $20,000,000 p.a.

Customers currently take credit as follows:
Days %age
30 20%
60 50%
90 30%
They are considering offering a discount of 1% for payment within 30 days. It is estimated that 60% of
customers will take advantage of the discount (and that the remainder will take a full 90 days).
The company’s bank overdraft rate is 15% p.a.
Calculate the net cost or benefit of the change of policy.
Should they offer the discount? (Assume 365 days in a year)
Hints: Net cost of offering discount $46,027 p.a. Therefore do not offer discount.
Example 22: Discount Policy. Stevens Company presents the following information:
Current annual credit sales: Rs.24,000,000
Collection period: 3 months
Terms: net/30
Rate of return: 18%
The company is considering offering a 4/10, net/30 discount. It anticipates that 30 percent of its customers
will take advantage of the discount. The collection period is expected to decrease to 2 months. Should the
discount policy be implemented?
Hints: Advantage of discount policy = Rs. 72,000. Implement.
The benefit in interest cost saved should exceed the cost of the discounts allowed.
The percentage cost of an early settlement discount to the company giving it can be estimated by the
formula:
365
Number of days beyond
1 the discount period
Cost of trade credit = -1
1 - Discount
Where d = the discount offered (5% = 5, etc.)
t = the reduction in the payment period in days that is necessary to obtain the early payment discount
Example 23: A company offers its goods to customers on 30 days' credit, subject to satisfactory trade
references. It also offers a 2% discount if payment is made within ten days of the date of the invoice.
Required
Calculate the cost to the company of offering the discount, assuming a 365 day year.
Hints: 44.6%
Example 24: Customers currently take three months credit. We are considering offering a discount of 4%
for payment within one month.
Sales are $12,000,000 p.a.
We are paying overdraft interest of 20% p.a.
Calculate the effective % cost p.a. of the discount.
Should we offer the discount?
Hints: 27.75% > 20% therefore better to not offer discount
Bad debt risk

The higher revenue resulting from easier credit terms should be sufficiently profitable to exceed the cost
of:
• Additional bad debts, and
• The additional investment necessary to achieve the higher sales.
Example 25: Grabbit Quick Co achieves current annual sales of $1,800,000. The cost of sales is 80% of
this amount, but bad debts average 1% of total sales, and the annual profit is as follows.
$
Sales 1,800,000
Less cost of sales 1,440,000
360,000
Less bad debts 18,000
Profit 342,000
The current debt collection period is one month, and the management consider that, if credit terms were
eased (Option A), the effects would be as follows.
Present policy Option A
Additional sales (%) – 25%
Average collection period 1 month 2 months
Bad debts (% of sales) 1% 3%
The company requires a 20% return on its investments. The costs of sales are 75% variable and 25%
fixed. Assume there would be no increase in fixed costs from the extra revenue and that there would be no
increase in average inventories or accounts payable. Which is the preferable policy, Option A or the
present one?
Hints: Option A profitable by $ (130,500-45,000) = $ 85,5 00
Example 26: Nelson Corporation reports the following information:

Selling price per unit Rs.70
Variable cost per unit Rs.45
Fixed cost per unit Rs.15
Annual credit sales 400,000 units
Collection period 3 months
Rate of return 19%
The company is considering easing its credit standards. If it does, the following is expected to result:
Sales will increase by 25 percent; collection period will increase to 3.72 months; bad debt losses are
anticipated to be 4 percent on the incremental sales; and collection costs will increase by Rs.34,000.
Should the proposed relaxation in credit standards be implemented?
Hints: Net benefits of easing credit standards = $ 1,454,500
Factoring
Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of
the money it is due to collect.
The main aspects of factoring include the following.

a) Administration of the client's invoicing, sales accounting and debt collection service
b) Credit protection for the client's debts, whereby the factor takes over the risk of loss from bad
debts and so 'insures' the client against such losses. This is known as a non-recourse service.
However, if a non-recourse service is provided, the factor, not the firm, will decide what action
to take against non-payers.
c) Making payments to the client in advance of collecting the debts. This is sometimes referred to
as 'factor finance' because the factor is providing cash to the client against outstanding debts.)
Benefits of factoring
a) The business receives early payment for most of its receivables which can be used to pay its
suppliers.
b) Optimum inventory levels can be maintained, with earlier cash received.
c) Growth can be financed through sales rather than by injecting fresh external capital.
d) The business gets finance linked to its volume of sales. In contrast, overdraft limits tend to be
determined by historical statements of financial position.
e) The managers of the business do not have to spend their time on the problems of slow-paying
accounts receivable.
f) The business does not incur the costs of running its own sales ledger department, and can use
the expertise of debtor management that the factor has.
Criticisms of factoring include:

 the factor’s charges may be high
 once a company has started to use a factor it is hard to rebuild its own sales ledger function
 the factor will collect receivables in a vigorous manner and this may damage the company’s
relationship with its clients
 the use of a factor may indicate that the company has cash flow problems (this last criticism is less
relevant in the modern business environment where outsourcing of support functions has become
very common).
Example 27: Our sales are $10,000,000 p.a. and customers currently pay as follows:
Month % of time
1 20%
2 30%
3 50%
We are considering whether or not to factor our debts. The factor will pay us 100% of debts after 1
month. The fee is 2% of turnover. As a result we will be able to lose some credit control staff at a saving
of $20,000 p.a.
The company’s bank overdraft rate is 18% p.a.`
Calculate the net cost or benefit p.a. of changing to the new policy.
Hints: Total benefit of using a factor $215,000 p.a.; Net benefit $15,00
Example 28: Velmin Co has a turnover of $700,000. Receivable days are currently 48 despite the
company only offering 30-days’ credit and bad debts are currently 3% of turnover. Velmin Co finances its
receivables using its overdraft which has an annual interest cost of 8%.
Velmin is considering the use of a factor. The factor would charge 4% of turnover for a non-recourse
agreement and would expect to reduce receivable days to 34 and bad debts to 2%. The factor would lend
Velmin 75% of the outstanding receivables and would charge Velmin 1% above their current overdraft
interest cost. It is anticipated that using the factor would reduce administration costs by $6,000 per
annum.
Required
Evaluate whether or not Velmin Co should use the factor.
Hints: Annual benefits = $ 28,659, Annual Costs = $ 28,000; Net benefits = $659
Example 29: A company makes annual credit sales of $1,500,000. Credit terms are 30 days, but its debt
administration has been poor and the average collection period has been 45 days with 0.5% of sales
resulting in bad debts which are written off.
A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of
credit sales. The company would save $30,000 a year in administration costs. The payment period would
be 30 days.
The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over
the current base rate). The company can obtain an overdraft facility to finance its accounts receivable at a
rate of 2.5% over base rate.
Should the factor's services be accepted? Assume a constant monthly revenue.
Hints: Current Total cost = $ 62,466; Cost of factor = $ 54,637; net saving from factoring is $ 7,829
Example 30: Davis Company is considering a factoring arrangement. The company’s sales are
$2,700,000, accounts receivable turnover is 9 times, and a 17 percent reserve on accounts receivable is
required by the factor.
The factor’s commission charge on average accounts receivable payable at the point of receivable
purchase is 2.0 percent. The factor’s interest charge is 16 percent on receivables after subtracting the
commission charge and reserve. The interest charge reduces the advance. What is the annual effective
cost under the factoring arrangement?
Hints: Proceeds received after reserve and interest = $238,680; Annual cost of factoring = $92,880;
Annual Effective cost = 38.9%.
Invoice Discounting
Invoice discounting is the purchase (by the provider of the discounting service) of trade debts at a
discount. Invoice discounting enables the company from which the debts are purchased to raise working
capital. The invoice discounter does not take over the administration of the client's sales ledger.
Managing foreign accounts receivable

Exporters have to address the problems of larger inventories and accounts receivable, and an
increased risk of bad debts due to the transportation time and additional paperwork involved in sending
goods abroad.
Reducing the investment in foreign accounts receivable
 Advances against collections – done by banks
 Negotiation of bills or cheques - where the bill or cheque is payable outside the exporter's
country
 Discounting bills of exchange.
 Documentary credits
 Forfaiting
Documentary credits ('letters of credit') provide a method of payment in international trade, which
gives the exporter a secure risk-free method of obtaining payment.
Forfaiting
Forfaiting is a method of export finance whereby a bank purchases from a company a number of sales
invoices, usually obtaining a guarantee of payment of the invoices.
The forfaiter buys the foreign accounts receivable from a seller at a discount and takes on all of the credit
risk from the transaction (without recourse). The receivables then become a form of debt instrument
which can be sold on the money market.
Countertrade
Countertrade is a means of financing trade in which goods are exchanged for other goods. Three parties
might be involved in a 'triangular' deal. Countertrade is thus a form of barter and can involve complex
negotiations and logistics. One of the main problems with countertrade is that the value of the goods
received in exchange may be uncertain.
5. Managing Accounts Payable

• Accounts payable arise from trade credit and are a spontaneous form of credit.
• Credit terms may vary among industries and among companies, although these tend to be similar
within an industry because of competitive pressures.
• Factors to consider:
- Company’s centralization of the financial function
- Number, size, and location of vendors
- Trade credit and the cost of alternative forms of short-term financing
- Control of disbursement float (i.e., amount paid but not yet credited to the payer’s
account)
- Inventory management system
- E-commerce and electronic data interchange (EDI), which is the customer-to-business
payment connection through the internet
The Economics of Taking a Trade Discount

• The cost of trade credit, when paid during the discount period, is 0%.
• The cost of trade credit, when paid beyond the discount period, is
365
Number of days beyond
Discount the discount period
Cost of trade credit = 1 + -1
1 - Discount
Example: If the credit terms are 2/10, net 40, and the company pays on the 30th day,
0.02
Cost of trade credit = 1 + - 1 = 44.585%
0.98
• Although paying beyond the net period reduces the cost of trade credit further, it brings into
question the company’s creditworthiness.
Evaluating accounts Payable Management

• The number of days of payables indicates how long, on average, the company takes to pay on its
accounts.
• We can evaluate accounts payable management by comparing the number of days of payables
with the credit terms.
Example 31: A supplier offers a 2% discount if invoices are paid within 10 days of receipt. Currently we
take 30 days to pay invoices and therefore do not receive the discount.
Calculate the annual % effective cost of refusing the discount.
Hints: 44.58%
Example 32: A company currently takes 40 days credit from suppliers on the basis that this is ‘free’
finance. Annual purchases are $100,000 and the company pays overdraft interest of 13%. Payment within
15 days would attract a 1.5% quick settlement discount.
Should the company pay sooner in order to take advantage of the discount?
Hints: 24.69% > 13% therefore do take the discount
6. Managing the Cash Position

• Management of the cash position of a company has a goal of maintaining positive cash balances
throughout the day.
• Forecasting short-term cash flows is difficult because of outside, unpredictable influences (e.g.,
the general economy).
• Companies tend to maintain a minimum balance of cash (a target cash balance) to protect against
a negative cash balance.
Examples of Cash Inflows and Outflows
Inflows Outflows
 Receipts from operations, broken down by  Payables and payroll disbursements,
operating unit, departments, etc. broken down by operating unit,
 Fund transfers from subsidiaries, joint departments, etc.
ventures, third parties  Fund transfers to subsidiaries
 Maturing investments  Investments made
 Debt proceeds (short and long term)  Debt repayments
 Other income items (interest, etc.)  Interest and dividend payments
 Tax refunds  Tax payments
Motives for holding Cash:

- Transaction motive: To hold enough Cash for the ordinary production-to-sales cycle.
- Precautionary motive: Buffer cash for unforeseen contingencies
- Speculative motive: To ensure that cash is available for possible rise in interest rate in
future.
Cash flow forecasts (Cash Budget)

 Cash flow forecasts show the expected receipts and payments during a forecast period and are a
vital management control tool, especially during times of recession.
 A cash flow forecast is thus a statement in which estimated future cash receipts and payments are
tabulated in such a way as to show the forecast cash balance of a business at defined intervals.
Example 33: You are presented with the following flow forecasted cash flow data for your organisation
for the period November 20X1 to June 20X2. It has been extracted from functional flow forecasts that
have already been prepared.
NovX1 DecX1 JanX2 FebX2 MarX2 AprX2 MayX2 JuneX2
$ $ $ $ $ $ $ $
Sales 80,000 100,000 110,000 130,000 140,000 150,000 160,000 180,000
Purchases 40,000 60,000 80,000 90,000 110,000 130,000 140,000 150,000
Wages 10,000 12,000 16,000 20,000 24,000 28,000 32,000 36,000
Overheads 10,000 10,000 15,000 15,000 15,000 20,000 20,000 20,000
Dividends 20,000 40,000
Capital 30,000 40,000
expenditure
You are also told the following.
(a) Sales are 40% cash 60% credit. Credit sales are paid two months after the month of sale.
(b) Purchases are paid the month following purchase.
(c) 75% of wages are paid in the current month and 25% the following month.
(d) Overheads are paid the month after they are incurred.
(e) Dividends are paid three months after they are declared.
(f) Capital expenditure is paid two months after it is incurred.
(g) The opening cash balance is $15,000.
The managing director is pleased with the above figures as they show sales will have increased by more
than 100% in the period under review. In order to achieve this he has arranged a bank overdraft with a
ceiling of $50,000 to accommodate the increased inventory levels and wage bill for overtime worked.
(a) Prepare a cash flow forecast for the six-month period January to June 20X2.
(b) Comment on your results in the light of the managing director’s comments and offer advice.
Hints: (a) c/f cash balance 22,000 20,000 36,000 (50,000) (83,000) (156,000)
The usefulness of cash flow forecasts

Cash position Appropriate management action
Short-term surplus Pay accounts payable early to obtain discount
Attempt to increase sales by increasing accounts receivable and
inventories
Make short-term investments
Short-term deficit Increase accounts payable by delaying payments to suppliers
Reduce accounts receivable by improving collection of overdue
payments
Arrange a bank overdraft facility, or increase the limit on an
existing facility
Long-term surplus Make long-term investments
Expand
Diversify
Replace/update non-current assets
Distribute the surplus to shareholders
Long-term deficit Raise long-term finance (such as via issue of share capital)
Consider shutdown/disinvestment opportunities
Methods of easing cash shortages

 Postponing capital expenditure
 Accelerating cash inflows encourage receivables for earlier payments
 Reversing past investment decisions by selling assets previously acquired
 Negotiating a reduction in cash outflows to postpone or reduce payments
 Longer credit might be taken from suppliers
 Loan repayments could be rescheduled
 Dividend payments could be reduced
Treasury management
A large organisation will have a treasury department to manage liquidity, short-term investment,
borrowings, foreign exchange risk and other, specialized areas such as forward contracts and futures.
Treasury management can be defined as: 'The corporate handing of all financial matters, the generation
of external and internal funds for business, the management of currencies and cash flows, and the
complex strategies, policies and procedures of corporate finance.' (Association of Corporate Treasurers)
Centralization of the treasury department

 Centralised liquidity management
 short-term investment opportunities for large volumes of cash
 Any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings
 Foreign exchange risk management is likely to be improved in a group of companies like
matching
 A specialist treasury department can employ experts with knowledge of dealing in forward
contracts, futures, options, eurocurrency markets, swaps, and so on. Localized departments could not
have such expertise.
 The centralised pool of funds required for precautionary purposes will be smaller than sum of
decentralized pool
 Through having a separate profit centre, attention will be focused on the contribution to group
profit performance
Possible advantages of decentralised cash management are as follows.
 Sources of finance can be diversified and can match local assets.

 Greater autonomy can be given to subsidiaries and divisions because of the closer relationships
they will have with the decentralised cash management function.
 A decentralised treasury function may be more responsive to the needs of individual operating
units.
 Since cash balances will not be aggregated at group level, there will be more limited
opportunities to invest such balances on a short-term basis.
Cash management models

Optimal cash holding levels can be calculated from formal models, such as the Baumol model and the
Miller-Orr model.
The Baumol model
The Baumol model is based on the idea that deciding on optimum cash balances is like deciding on
optimum inventory levels.
2
Q
i
Where
S = the amount of cash to be used in each time period
C = the cost per sale of securities
i = the interest cost of holding cash or near cash equivalents
Q = the total amount to be raised to provide for S
Example 34: Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for
$24,000 of cash over each period of one year for the foreseeable future. The interest cost of new funds is
12% per annum; the interest rate earned on short-term securities is 9% per annum. How much finance
should Finder raise at a time?
Hints: $80,000; This amount is raised every 80,000 x24,000 = 31/3 years.
Example 35: Green Corporation anticipates a cash requirement of Rs.1,000 over a 1- month period. It is
expected that cash will be paid uniformly. The annual interest rate is 24 percent. The transaction cost of
each borrowing or withdrawal is Rs.30. (a) What is the optimal cash balance? (b) What is the average
cash balance?
Hints: (a) The optimum cash balance is: Rs.1,732:05; (b) The average cash balance is: Rs.866:03
Example 36: Next year a company forecasts a cash requirement of $1,500,000, the use being constant
throughout the year.
The company has investments in excess of this amount which are earning 9.5% p.a.
The company earns interest of 5% on their current account bank balance.
The cost of selling investments is $150 per transaction
(a) If the company sells $150,000 of investments each time, calculate the total cost p.a. to the
company.
(b) What is the optimal economic quantity of cash to transfer each time in order to minimize costs?
(c) At the EOQ, what is the total cost p.a. to the company?
Hints: (a) $76,125; (b) =$100,000 each time; (c) $75,750
Drawbacks of the Baumol model

 In reality, it is unlikely to be possible to predict amounts required over future periods with much
certainty.
 No buffer inventory of cash is allowed for. There may be costs associated with running out of cash.
 There may be other normal costs of holding cash which increase with the average amount held.
The Miller-Orr model

The Miller-Orr model of cash management is developed for businesses with uncertain cash inflows and
outflows. This approach allows lower and upper limits of cash balance to be set and determine the return
point (target cash balance). This is different from the Baumol-Tobin model, which is based on the
assumption that the cash spending rate is constant.
Assumptions
The Miller-Orr model of cash management can be used if the following assumptions are met:
 The cash inflows and cash outflows are stochastic. In other words, each day a business may have
both different cash payments and different cash receipts.
 The daily cash balance is normally distributed, i.e., it occurs randomly.
 There is a possibility to invest idle cash in marketable securities.
 There is a transaction fee when marketable securities are bought or sold.
 A business maintains the minimum acceptable cash balance, which is called the lower limit.
Formula
Return point = Lower limit + (1/3 x spread)
3 Transaction Cost x Variance of Cash flow /
3
4
Upper limit = Lower Limit + Spread
Note: Variance and interest rate should be expressed in daily terms
Example 37: The management of Stilmill Inc. has set a safety cash balance of $50,000. The standard
deviation (σ) of the daily cash balance during the last year was $37,500, and the transaction cost was $75.
The company also has the opportunity to invest idle cash in marketable securities at an annual interest rate
of 8%.
Hints: Spread = $ 213,325; Return point = $121,108; Upper Limit = $263,325
Example 38: The following data applies to a company.

1 The minimum cash balance is $8,000.
2 The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of $2,000 per day.
3 The transaction cost for buying or selling securities is $50. The interest rate is 0.025% per day.
You are required to formulate a decision rule using the Miller-Orr model.
Hints: Spread = $ 25,302; Return point = $16,433; Upper Limit = $33,302
Example 39: A company has decided it needs a minimum balance of $10,000. The transaction cost (of
making transfers to/from deposit) is $5 per transaction. The standard deviation of cash flows is $2,000 per
day, and the interest rate is 5.11% p.a. (or 5.11/365 = 0.014% per day)
What should be the upper and lower limits, and the return point?
Hints: Upper limit = 24,250; Return point = 14,750
Limitations
When the Miller-Orr model of cash management is applied, we should take into account the following
limitations:
 An increase in transaction cost results in an increase of spread and a higher return point.
 The higher the standard deviation (σ) of daily cash balance, the wider the spread and higher return
point. A higher volatility of the daily cash balance also means a higher probability of reaching the
lower or upper limit.
 By contrast, an increase in the return on investment in marketable securities will lead to a narrower
spread and lower return point because the opportunity cost of holding cash is also growing, so a
business will seek to decrease its cash holdings.
7. Investing Short-term Funds

• Short-term investments are temporary stores of funds.
- Examples include U.S. Treasury Bills, eurodollar time deposits, repurchase agreements,
commercial paper, and money market mutual funds.
• Considerations:
- Liquidity - Profitability
- Maturity - Credit risk
- Yield - Requirement of collateral
Yields on Short-Term Securities

• The nominal rate is the stated rate of interest, based on the face value of the security.
• The yield is the actual return on the investment if held to maturity.
There are different conventions for stating a yield
Yield Formula
Money market yield Face value - Purchase price 360
×
Purchase price Number of days to maturity
Discount-basis yield Face value - Purchase price 360
×
Face value Number of days to maturity
Short-term Funds Investments

 Bank Deposits
 Short-term debt instrument – T-bills, commercial paper
 Long-term Debt Instrument – Government bonds
 Investment in shares of listed companies
Example 39: (a) What would be your annualized money market yield and discount basis yield on
the purchase of a 182-day Treasury-Bill for $4,925 that pays $5,000 at maturity? Hints: 3.01%;
2.97%
(b) The price of $8,000 face value commercial paper is $7,930. if the annualized yield is 4%, when will
the paper mature? Hints: 79.5 days.
(c) How much would you pay for a Treasury bill that matures in one year and pays $10,000 if you require
a 3% return? Hints: $9,708.74
(d) How much would you pay for a commercial paper that matures in one 90 days and pays $10,000 if
you require a 4% return? Hints: $9,900.99.
Short-term Investment Strategies

Short-Term Investment Strategies
Short‐Term Investment • Active strategy
Strategies • Matching strategy: Matching
maturities with cash flows
• Mismatching strategy: Intentionally
Active Passive mismatching maturities with cash
flow timing to produce higher returns:
riskier strategy
Matching • Laddering strategy: Spreading out
Strategy maturities over time
• Passive
Mismatching • Emphasizing safety and liquidity
Strategy
Laddering
Strategy
8. Managing Short-term Financing

• The objective of a short-term financing strategy is to ensure that the company has sufficient
funds, but at a cost (including risk) that is appropriate.
• Sources of financing
Bank Sources Nonbank Sources
• Uncommitted line of credit • Asset-based loan

• Regular line of credit • Commercial paper
• Overdraft line of credit
• Revolving credit agreement
• Collateralized loan
• Discounted receivables
• Banker’s acceptances
• Factoring
Which Short-term Financing?
• Characteristics that determine the choice of financing:
- Size of borrower
- Creditworthiness of borrower
- Access to different forms of financing
- Flexibility of borrowing options
• Asset-based loans are loans secured by an asset
Accounts Receivable Inventory
•Blanket lien •Inventory blanket lien
•Assignment of accounts receivable •Trust receipt arrangement
•Factoring •Warehouse receipt arrangement
9. Working capital investment policy

9.1 A conservative approach
A conservative working capital investment policy aims to reduce the risk of system breakdown by
holding high levels of working capital. However, the cumulative effect on these policies can be that the
firm carries a high burden of unproductive assets, resulting in a financing cost that can destroy
profitability.
9.2 An aggressive approach

An aggressive working capital investment policy aims to reduce this financing cost and increase
profitability by cutting inventories, speeding up collections from customers and delaying payments to
suppliers.
The potential disadvantage of this policy is an increase in the chances of system breakdown through
running out of inventory or loss of goodwill with customers and suppliers.
9.3 A moderate approach

A moderate working capital investment policy is a middle way between the aggressive and conservative
approaches. It is useful for different ways that individual organisations deal with working capital and the
trade-off between risk and return.
9.4 Permanent and fluctuating current assets

In order to understand working capital financing decisions, assets can be divided into three different
types.
(a) Non-current (fixed) assets are long-term assets from which an organisation expects to derive benefit
over a number of periods; for example, buildings or machinery.
(b) Permanent current assets are the amount required to meet long-term minimum needs and sustain
normal trading activity; for example, inventory and the average level of accounts receivable.
(c) Fluctuating current assets are the current assets which vary according to normal business activity;
for example, due to seasonal variations.
Working Capital Management – Past Questions

December 2018
1. Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack
business administration skills.
The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large
multinational car manufacturing companies and are often late in paying their invoices. Oscar Co is a
rapidly growing company and revenue has doubled in the last four years. Oscar Co has focused in this
time on product development and customer service, and managing trade receivables has been neglected.
Oscar Co’s average trade receivables are currently $5·37m, and bad debts are 2% of credit sales revenue.
Partly as a result of poor credit control, the company has suffered a shortage of cash and has recently
reached its overdraft limit.
The four founders have spent large amounts of time chasing customers for payment. In an attempt to
improve trade receivables management, Oscar Co has approached a factoring company.
The factoring company has offered two possible options:
Option 1
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a
full recourse basis. The factor would charge a service fee of 0·5% of credit sales revenue per year. Oscar
Co estimates that this would result in savings of $30,000 per year in administration costs. Under this
arrangement, the average trade receivables collection period would be 30 days.
Option 2
Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a
non-recourse basis. The factor would charge a service fee of 1·5% of credit sales revenue per year.
Administration cost savings and average trade receivables collection period would be as Option 1. Oscar
Co would be required to accept an advance of 80% of credit sales when invoices are raised at an interest
rate of 9% per year.
Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per
year.
Required:
(a) Calculate the costs and benefits of each of Option 1 and Option 2 and comment on your
findings. (8 marks)
(b) Discuss reasons (other than costs and benefits already calculated) why Oscar Co may benefit
from the services offered by the factoring company. (6 marks)
(c) Discuss THREE factors which determine the level of a company’s investment in working capital.
(6 marks) (20 marks)
Hints:
(a) Option 1: Net benefit $104,804; Option 2: Net benefit $347,982
(b) Economies of specialization; Scale economies; Free up management time; Bad debts insurance;
Accelerate cash inflow; Finance through growth
(c) The nature of the industry and the length of the working capital cycle; Working capital investment
policy; Efficiency of management and terms of trade
June 2017
2. It is the middle of December 20X6 and Pangli Co is looking at working capital management for January
20X7.
Forecast financial information at the start of January 20X7 is as follows:
Inventory $455,000
Trade receivables $408,350
Trade payables $186,700
Overdraft $240,250
All sales are on credit and they are expected to be $3·5m for 20X6. Monthly sales are as follows:
November 20X6 (actual) $270,875
December 20X6 (forecast) $300,000

January 20X7 (forecast) $350,000
Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit, only 60% of
customers pay in the month following purchase, while the remaining customers take an additional month
of credit.
Inventory is expected to increase by $52,250 during January 20X7.
Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the remaining 30% until
the end of February 20X7. All suppliers of the company require payment within 30 days. Credit purchases
from suppliers during January 20X7 are expected to be $250,000.
Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating cash outflows are
expected to be $146,500 in January 20X7. Pangli Co has no cash and relies on its overdraft to finance
daily operations. The company has no plans to raise long-term finance during January 20X7.
Assume that each year has 360 days.
Required:
(a) (i) Calculate the cash operating cycle of Pangli Co at the start of January 20X7. (2 marks)
(ii) Calculate the overdraft expected at the end of January 20X7. (4 marks)
(iii) Calculate the current ratios at the start and end of January 20X7. (4 marks)
(b) Discuss FIVE techniques that Pangli Co could use in managing trade receivables. (10 marks) (20
marks)
Hints:
(a)(i) Cash operating cycle of Pangli Co = 78 + 42 – 32 = 88 days
(a)(ii) Overdraft expected at end of January 20X7 299,090
(a)(iii) Current ratio at start of January 20X7 = 863,350/426,950 = 2·03 times;
Current ratio at end of January 20X7 = 977,250/605,100 = 1·62 times
(b) Assessing creditworthiness; Managing accounts receivable; Collecting amounts owing; Offering early
settlement discounts; Using factoring and invoice discounting; Managing foreign accounts receivable
September 2016
3. Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables
after 60 days.
One of its suppliers has offered the company an early settlement discount of 0·5% for payment within 30
days.
Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud
Co buys components worth $1·5 million per year from this supplier.
From a different supplier, Nesud Co purchases $2·4 million per year of Component K at a price of $5 per
component.
Consumption of Component K can be assumed to be at a constant rate throughout the year. The company
orders components at the start of each month in order to meet demand and the cost of placing each order
is $248·44. The holding cost for Component K is $1·06 per unit per year.
The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into
irrecoverable debts. In addition, she has been advised that customers of the company take an average of
65 days to settle their accounts, even though Nesud Co requires settlement within 40 days.
Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in
a year.
Required:
(a) Evaluate whether Nesud Co should accept the early settlement discount offered by its supplier.
(4 marks)
(b) Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering
Component K. (6 marks)
(c) Critically discuss how Nesud Co could improve the management of its trade receivables. (10
marks) (20 marks)
Hints:
(a) Net benefit of discount = 7,500 – 5,000 – 500= $2,000 per year
On financial grounds, Nesud Co should accept the supplier’s early settlement discount offer.
(b) Total cost of EOQ ordering policy = 7,950 + 7,950 = $15,900
On financial grounds, Nesud Co should adopt an EOQ approach to ordering Component K as there is a
reduction in cost of $8,281.
(c) Credit analysis; Credit control; Collection of amounts owed; Factoring of trade receivables
June 2016
4. Crago Co is concerned that it may be overtrading. Financial information relating to the company is as
follows.
20X5 20X4
$000 $000 $000 $000
Credit sales income 17,100 12,000
Cost of sales 8,550 7,500
Current assets
Inventory 2,500 2,100
Trade receivables 2,000 1,000
–––––– ––––––
4,500 3,100
Current liabilities
Trade payables 1,900 1,250
Overdraft 2,400 850
–––––– ––––––
4,300 2,100
––––––– –––––––
Net working capital 200 1,000
––––––– –––––––
Long-term debt 3,000 3,000
Companies which are similar to Crago Co have the following average values for 20X5:
Inventory days 65 days
Trade receivables days 30 days
Trade payables days 50 days
Current ratio 1·7 times
Quick ratio 0·8 times
Assume there are 360 days in each year.
Required:
Evaluate whether Crago can be considered to be overtrading and discuss how overtrading can be
overcome. Note: Up to 4 marks are available for calculations. (10 marks)
Hints:
Number of indicators of overtrading:
Rapid increase in sales revenue; Increased reliance on short-term finance; Rapid increase in current
assets; Decline in solvency and liquidity ratios; Overcoming overtrading
Inventory days (20x5/20x4)= 105 days; 101 days
Trade receivable days = 42 days; 30 days
Trade payables days = 80 days; 60 days
Current ratio = 1·05 times; 1·5 times
Quick ratio = 0·5 times; 0·5 times
Sales income/net working capital = 86 times; 12 times
Short-term funding of current assets = 96%; 68%
Sales income growth: 17,100/12,000 = 42·5%
Inventory growth: 2,500/2,100 = 19%

Trade receivables growth: 2,000/1,000 = 100%
Trade payables growth: 1,900/1,250 = 52%
Overdraft growth: 2,400/850 = 182%
December 2015
5. ZXC Co currently has income of $30 million per year, of which 80% is from credit sales, and a net profit
margin of 10%. Due to fierce competition, ZXC Co has lost market share and is looking for ways to win
back former customers and to keep the loyalty of existing customers. The sales director has pointed out
that a major competitor of ZXC Co currently offers an early settlement discount of 0·5% for settlement
within 30 days, while ZXC Co itself does not offer an early settlement discount. He suggests that if ZXC
Co could match this early settlement discount, annual income from credit sales would increase by 20%.
Credit customers of ZXC Co take an average of 51 days to settle invoices. Approximately 0·5% of the
company’s credit sales have historically become bad debts each year and written off as irrecoverable. The
finance director has been advised that offering an early settlement discount of 0·5% for payment within
30 days would increase administration costs by $35,000 per year, while 75% of credit customers would be
likely to take the discount. The credit controller believes that bad debts would fall to 0·375% of credit
sales if the early settlement discount were introduced.
ZXC Co has an average short-term cost of finance of 4% per year. Assume that there are 360 days in each
year.
Required:
(a) Evaluate whether ZXC Co should introduce the early settlement discount. (6 marks)
(b) Discuss TWO ways in which a company could reduce the risk associated with foreign accounts
receivable. (4 marks) (10 marks)
Hints:
(a) Net benefit of proposed early settlement discount = 372,200
June 2015
6. The finance director of Widnor Co has been looking to improve the company’s working capital
management.
Widnor Co has revenue from credit sales of $26,750,000 per year and although its terms of trade require
all credit customers to settle outstanding invoices within 40 days, on average customers have been taking
longer. Approximately 1% of credit sales turn into bad debts which are not recovered.
Trade receivables currently stand at $4,458,000 and Widnor Co has a cost of short-term finance of 5% per
year.
The finance director is considering a proposal from a factoring company, Nokfe Co, which was invited to
tender to manage the sales ledger of Widnor Co on a with-recourse basis. Nokfe Co believes that it can
use its expertise to reduce average trade receivables days to 35 days, while cutting bad debts by 70% and
reducing administration costs by $50,000 per year. A condition of the factoring agreement is that the
company would also advance Widnor Co 80% of the value of invoices raised at an interest rate of 7% per
year. Nokfe Co would charge an annual fee of 0·75% of credit sales.
Assume that there are 360 days in each year.
Required:
(a) Advise whether the factor’s offer is financially acceptable to Widnor Co. (7 marks)
(b) Briefly discuss how the creditworthiness of potential customers can be assessed. (3 marks)
(10 marks)
Hints:
(a) The factor’s offer is financially acceptable to Widnor Co as it results, on current figures, in a net
benefit of $87,879 per year.
December 2015
7. Flit Co is preparing a cash flow forecast for the three-month period from January to the end of March.
The following sales volumes have been forecast:
December January February March April
Sales (units) 1,200 1,250 1,300 1,400 1,500
Notes:
1. The selling price per unit is $800 and a selling price increase of 5% will occur in February. Sales are all
on one month’s credit.
2. Production of goods for sale takes place one month before sales.
3. Each unit produced requires two units of raw materials, costing $200 per unit. No raw materials
inventory is held. Raw material purchases are on one months’ credit.
4. Variable overheads and wages equal to $100 per unit are incurred during production, and paid in the
month of production.
5. The opening cash balance at 1 January is expected to be $40,000.
6. A long-term loan of $300,000 will be received at the beginning of March.
7. A machine costing $400,000 will be purchased for cash in March.
Required:
(a) Calculate the cash balance at the end of each month in the three-month period. (5 marks)
(b) Calculate the forecast current ratio at the end of the three-month period. (2 marks)
(c) Assuming that Flit Co expects to have a short-term cash surplus during the three-month period,
discuss whether this should be invested in shares listed on a large stock market. (3 marks) (10
marks)
Hints:
(a) Closing Cash balance (Jan/Feb/March $000) = 370; 710; 992
(b) Current ratio = (750,000 + 1,176,000 + 992,000)/600,000 = 4·9 times
June 2014
8. The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:
$000 $000
Inventory 5,700
––––––
Trade payables 2,137
Overdraft 4,682 6,819
–––––– –––––––
Net current assets 5,456
–––––––
For the year to end of March 2014, CSZ Co had domestic and foreign sales of $40 million, all on credit,
while cost of sales was $26 million. Trade payables related to both domestic and foreign suppliers.
For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at $40 million while
cost of sales will fall to 60% of sales. The company expects current assets to consist of inventory and
trade receivables, and current liabilities to consist of trade payables and the company’s overdraft.
CSZ Co also plans to achieve the following target working capital ratio values for the year to the end of
March 2015:
Inventory days: 60 days
Trade receivables days: 75 days
Trade payables days: 55 days
Current ratio: 1·4 times
Required:
(a) Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 2014
and discuss whether a working capital cycle should be positive or negative. (6 marks)
(b) Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working
capital of CSZ Co at the end of March 2015. (5 marks)
(c) Analyse and compare the current asset and current liability positions for March 2014 and
March 2015, and discuss how the working capital financing policy of CSZ Co would have changed.
(8 marks)
(d) Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign
currency transaction risk arising from its continuing business activities. (6 marks)
(25 marks)
Hints:
(a) Working capital cycle of CSZ Co = 80 + 60 – 30 = 110 days
(b) The target quick ratio (acid test ratio) = 8,219,178/8,688,846 = 0·95 times
Target sales/net working capital ratio = 40,000,000/3,475,538 = 11·5 times
(c ) Net current assets (March 2014/2015) = $5,456,000/ 3,476,000
The overdraft as a percentage of current liabilities will fall from 69% (4,682/6,819) to 58%
(5,072/8,688). Even though the overdraft is expected to increase by 8·3%, current liabilities are expected
to increase by 27·4% (8,688/6,819). Most of this increase is expected to be carried by trade payables,
which will rise by 69·2% (3,616/2,137), with trade payables days increasing from 30 days to 55 days.
At the end of March 2014, current liabilities were 56% of current assets (100 x 6,819/12,275), suggesting
that 44% of current assets were financed from a long-term source. At the end of March 2015, current
liabilities are expected to be 71% of current assets (100 x 8,688/12,164), suggesting that 29% of current
assets are financed from a long-term source. This increasing reliance on short-term finance implies an
aggressive change in the working capital financing policy of CSZ Co.
(d) Currency of invoice; Matching; Leading and lagging
December 2013
9. Plot Co sells both Product P and Product Q, with sales of both products occurring evenly throughout the
year.
Product P
The annual demand for Product P is 300,000 units and an order for new inventory is placed each month.
Each order costs $267 to place. The cost of holding Product P in inventory is 10 cents per unit per year.
Buffer inventory equal to 40% of one month’s sales is maintained.
Product Q
The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit
on 60 days credit. The supplier has offered an early settlement discount of 1% for settlement of invoices
within 30 days. Other information
Plot Co finances working capital with short-term finance costing 5% per year. Assume that there are 365
days in each year.
Required:
(a) Calculate the following values for Product P:
(i) The total cost of the current ordering policy; (3 marks)
(ii) The total cost of an ordering policy using the economic order quantity; (3 marks)
(iii) The net cost or saving of introducing an ordering policy using the economic order
quantity. (1 mark)
(b) Calculate the net value in dollars to Plot Co of accepting the early settlement discount for
Product Q.(5 marks)
(c) Discuss how invoice discounting and factoring can aid the management of trade receivables. (6
marks)
(d) Identify the objectives of working capital management and discuss the central role of working
capital management in financial management. (7 marks) (25 marks)
Hints:
(a)(i) Total Cost of current ordering policy = 3,204 + 2,250 = $5,454 per year
(a)(ii) Cost of ordering policy using economic order quantity (EOQ) = $2,003 + $3,000 = $5,003 per
year
(a) (iii) Saving from introducing EOQ ordering policy = 5,454 – 5,003 = $451 per year
(b) Net value of offer of discount = 4,560 – 1,893 = $2,667
June 2013
10. TGA Co, a multinational company, has annual credit sales of $5·4 million and related cost of sales are
$2·16 million.
Approximately half of all credit sales are exports to a European country, which are invoiced in euros.
Financial information relating to TGA Co is as follows:
$000 $000
Inventory 473·4
Trade receivables 1,331·5 1,804·9
–––––––
Trade payables 177·5
Overdraft 1,326·6 1,504·1
––––––– –––––––
Net working capital 300·8
–––––––
TGA Co plans to change working capital policy in order to improve its profitability. This policy change
will not affect the current levels of credit sales, cost of sales or net working capital. As a result of the
policy change, the following working capital ratio values are expected:
Other relevant financial information is as follows:
Short-term dollar borrowing rate 5% per year
Short-term dollar deposit rate 4% per year
Assume there are 365 days in each year.
Required:
(a) For the change in working capital policy, calculate the change in the operating cycle, the effect
on the current ratio and the finance cost saving. Comment on your findings. (8 marks)
(b) Discuss the key elements of a trade receivables management policy. (7 marks)
(c) Explain the different types of foreign currency risk faced by a multinational company. (6 marks)
(d) TGA Co expects to receive €500,000 from export sales at the end of three months. A forward rate of
€1·687 per $1 has been offered by the company’s bank and the spot rate is €1·675 per $1. TGA Co can
borrow short term in the euro at 9% per year.
Required:
Calculate the dollar income from a forward market hedge and a money market hedge, and indicate
which hedge would be financially preferred by TGA Co. (4 marks) (25 marks)
Hints:
(a) (i) The change in the operating cycle is therefore a decrease of 73 days.
(ii) The effect on the current ratio is to increase it from 1·20 to 1·33 times.
(iii) The finance cost saving arises from the decrease in the overdraft from $1,326,600 to $646,049, a
reduction of $680,551, with a saving of 5% per year or $34,028 per year.
(b) The key elements of a trade receivables policy are credit analysis, credit control and receivables
collection.
(c) Foreign currency risk can be divided into transaction risk, translation risk and economic risk.
December 2012
11. KXP Co is an e-business which trades solely over the internet. In the last year the company had sales of
$15 million. All sales were on 30 days’ credit to commercial customers.
Extracts from the company’s most recent statement of financial position relating to working capital are as
follows:
$000
Trade receivables 2,466
Overdraft 3,000
In order to encourage customers to pay on time, KXP Co proposes introducing an early settlement
discount of 1% for payment within 30 days, while increasing its normal credit period to 45 days. It is
expected that, on average, 50% of customers will take the discount and pay within 30 days, 30% of
customers will pay after 45 days, and 20% of customers will not change their current paying behaviour.
KXP Co currently orders 15,000 units per month of Product Z, demand for which is constant. There is
only one supplier of Product Z and the cost of Product Z purchases over the last year was $540,000. The
supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP
Co $150 to place and the holding cost is 24 cents per unit per year.
KXP Co has an overdraft facility charging interest of 6% per year.
Required:
(a) Calculate the net benefit or cost of the proposed changes in trade receivables policy and
comment on your findings. (6 marks)
(b) Calculate whether the bulk purchase discount offered by the supplier is financially acceptable
and comment on the assumptions made by your calculation. (6 marks)
(c) Identify and discuss the factors to be considered in determining the optimum level of cash to be
held by a company. (5 marks)
(d) Discuss the factors to be considered in formulating a trade receivables management policy. (8
marks) (25 marks)
Hints:
(a) Net cost of proposed changes in receivables policy = 75,000 – 48,097 = $26,903
Comment
The proposed changes in trade receivables policy are not financially acceptable. However, if the trade
terms offered are comparable with those of its competitors, KXP Co needs to investigate the reasons for
the (on average) late payment of current customers. This analysis also assumes constant sales and no bad
debts, which is unlikely to be the case in reality.
(b) Total cost of current inventory policy = 540,000 + 1,800 + 1,800 = $543,600 per year
Revised total cost of inventory policy = 529,200 + 900 + 3,600 = $533,700 per year
Evaluation of offer of bulk purchase discount
Net benefit of taking bulk purchase discount = 543,600 – 533,700 = $9,900 per year
The bulk purchase discount looks to be financially acceptable. However, this evaluation is based on a
number of unrealistic assumptions. For example, the ordering cost and the holding cost are assumed to
be constant, which is unlikely to be true in reality. Annual demand is assumed to be constant, whereas in
practice seasonal and other changes in demand are likely.
(c) The transactions need for cash; the precautionary need for cash; the speculative need for cash; the
availability of finance.
June 2012
12. The following financial information relates to Wobnig Co.
Income statement extracts
2011 2010
$000 $000
Revenue 14,525 10,375
Cost of sales 10,458 6,640

––––––– –––––––
Profit before interest and tax 4,067 3,735
Interest 355 292
––––––– –––––––
Profit before tax 3,712 3,443
Taxation 1,485 1,278
––––––– –––––––
Distributable profit 2,227 2,165
––––––– –––––––
Statement of financial position extracts

2011 2010
$000 $000 $000 $000
Non-current assets 15,284 14,602
Current assets
Inventory 2,149 1,092
–––––– ––––––
5,349 2,826
––––––– –––––––
Total assets 20,633 17,428
––––––– –––––––
Current liabilities
Trade payables 2,865 1,637
Overdraft 1,500 250
–––––– ––––––
4,365 1,887
Equity
Ordinary shares 8,000 8,000
Reserves 4,268 3,541
–––––– ––––––
12,268 11,541
Long-term liabilities
7% Bonds 4,000 4,000
––––––– –––––––
Total liabilities 20,633 17,428
––––––– –––––––
Average ratios for the last two years for companies with similar business operations to Wobnig Co are as
follows:
Current ratio 1·7 times
Quick ratio 1·1 times
Sales revenue/net working capital 10 times
Required:
(a) Using suitable working capital ratios and analysis of the financial information provided,
evaluate whether Wobnig Co can be described as overtrading (undercapitalized). (12 marks)
(b) Critically discuss the similarities and differences between working capital policies in the
following areas:
(i) Working capital investment;

(ii) Working capital financing. (9 marks)
(c) Wobnig Co is considering using the Miller-Orr model to manage its cash flows. The minimum cash
balance would be $200,000 and the spread is expected to be $75,000.
Required:
Calculate the Miller-Orr model upper limit and return point, and explain how these would be used
to manage the cash balances of Wobnig Co. (4 marks) (25 marks)
Hints:
(a) Overall, it can be concluded that there are several indications that Wobnig Co is moving, or has
moved, into an overtrading (undercapitalisation) position.
Increase in revenue = 100 x (14,525 – 10,375)/10,375 = 40%
Increase in long-term finance = 100 x (16,268 – 15,541)/15,541 = 4·7%
2011 2010
Net profit margin 100 x 4,067/14,525 = 28% 100 x 3,735/10,375 = 36%
Current ratio 5,349/4,365 = 1·2 times 2,826/1,887 = 1·5 times
Quick ratio 3,200/4,365 = 0·7 times 1,734/1,887 = 0·9 times
Inventory days 365 x 2,149/10,458 = 75 days 365 x 1,092/6,640 = 60 days
Receivables days 365 x 3,200/14,525 = 80 days 365 x 1,734/10,375 = 61 days
Payables days 365 x 2,865/10,458 = 100 days 365 x 1,637/6,640 = 90 days
Net working capital 5,349 – 4,365 = $984,000 2,826 – 1,887 = $939,000
Sales/net working capital 14,525/984 = 15 times 10,375/939 = 11 times
(c) Calculation of upper limit
The upper limit is the sum of the lower limit and the spread. If we use the minimum cash balance as the
lower limit, the upper limit = 200,000 + 75,000 = $275,000
Calculation of return point
The return point is the sum of the lower limit and one-third of the spread.
Return point = 200,000 + (75,000/3) = 200,000 + 25,000 = $225,000
Use in managing cash balances
The Miller-Orr model provides decision rules about when to invest surplus cash (if a cash balance
increases to a high level), and about when to sell short-term investments (if a cash balance falls to a low
level). By using these decision rules, the cash balance is kept between the upper and lower limits set by
the Miller-Orr model. When the cash balance reaches the upper limit, $50,000 is invested in short-term
securities. This is equal to the upper limit minus the return point ($275,000 – $225,000). When the cash
balance falls to the lower limit, short-term securities worth $25,000 are sold for cash. This is equal to the
return point minus the lower limit ($225,000 – $200,000).
December 2011
13. Extracts from the recent financial statements of Bold Co are given below.
$000
Turnover 21,300
Cost of sales 16,400
–––––––
Gross profit 4,900
–––––––
$000 $000
Non-current assets 3,000
Current assets
Inventory 4,500
Trade receivables 3,500
––––––
8,000
–––––––
Total assets 11,000
–––––––
Current liabilities
Overdraft 3,000
––––––
6,000
Equity
Ordinary shares 1,000
Reserves 1,000
––––––
2,000
Non-current liabilities
Bonds 3,000
–––––––
11,000
–––––––
A factor has offered to manage the trade receivables of Bold Co in a servicing and factor-financing
agreement. The factor expects to reduce the average trade receivables period of Bold Co from its current
level to 35 days; to reduce bad debts from 0·9% of turnover to 0·6% of turnover; and to save Bold Co
$40,000 per year in administration costs. The factor would also make an advance to Bold Co of 80% of
the revised book value of trade receivables. The interest rate on the advance would be 2% higher than the
7% that Bold Co currently pays on its overdraft. The factor would charge a fee of 0·75% of turnover on a
with-recourse basis, or a fee of 1·25% of turnover on a non-recourse basis.
Assume that there are 365 working days in each year and that all sales and supplies are on credit.
Required:
(a) Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the
cash operating cycle and the level of investment in working capital. Your answer should include a
discussion of relevant working capital policy and the nature of business operations. (7 marks)
(b) Calculate the cash operating cycle of Bold Co. (Ignore the factor’s offer in this part of the
question). (4 marks)
(c) Calculate the value of the factor’s offer:
(i) on a with-recourse basis;
(ii) on a non-recourse basis. (7 marks)
(d) Comment on the financial acceptability of the factor’s offer and discuss the possible benefits to
Bold Co of factoring its trade receivables. (7 marks) (25 marks)
Hints:
(b) Cash operating cycle = 100 + 60 – 67 = 93 days
(c) Calculation of value of with-recourse offer
Net benefit of with-recourse offer 13,497
Calculation of value of non-recourse offer
Net benefit of non-recourse offer 34,797
(d) The expertise of the factor; Insurance against bad debts; Factor finance; Lower administration
costs.
June 2011
14. (a) ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan several years ago
when peso interest rates were relatively cheap compared to dollar interest rates. Economic difficulties
have now increased peso interest rates while dollar interest rates have remained relatively stable. ZPS Co
must pay interest of 5,000,000 pesos in six months’ time. The following information is available.
Per $
Spot rate: pesos 12·500 – pesos 12·582
Six-month forward rate: pesos 12·805 – pesos 12·889
Interest rates that can be used by ZPS Co:
Borrow Deposit
Peso interest rates: 10·0% per year 7·5% per year
Dollar interest rates: 4·5% per year 3·5% per year
(b) ZPS Co places monthly orders with a supplier for 10,000 components that are used in its
manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full
within 90 days, which ZPS Co meets, and the cost per component is $7·50. The cost of ordering is $200
per order, while the cost of holding components in inventory is $1·00 per component per year.
The supplier has offered either a discount of 0·5% for payment in full within 30 days, or a discount of
3·6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding
components in inventory would increase to $2·20 per component per year due to the need for a larger
storage facility.
Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 4·5% per year.
Required:
(i) Discuss the factors that influence the formulation of working capital policy; (7 marks)
(ii) Calculate if ZPS Co will benefit financially by accepting the offer of:
(1) the early settlement discount;
(2) the bulk purchase discount. (7 marks) (25 marks)
Hints:
(b) (i) Working capital policies can cover the level of investment in current assets, the way in which
current assets are financed, and the procedures to follow in managing elements of working capital such
as inventory, trade receivables, cash and trade payables. The twin objectives of working capital
management are liquidity and profitability, and working capital policies support the achievement of these
objectives. There are several factors that influence the formulation of working capital policies, as follows.
Nature of the business
The operating cycle
Terms of trade
Risk appetite of company
(ii) Early settlement discount
Since the increase in financing cost is $2,157 greater than the discount offered, ZPS Co will not benefit
financially by taking the early settlement discount.
Bulk purchase discount
ZPS Co will benefit financially if it takes the bulk discount offered by the supplier, as it saves $6,000 per
year in inventory costs or 0·66% of current inventory costs.

Working Capital Management

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WORKING CAPITAL MANAGEMENT, ACCA

4. Working Capital Management

Internal Factors External Factors

• Company size and growth rates • Banking services

2. Managing and measuring Liquidity

Current assets Ability to satisfy current liabilities

Short-term Ability to satisfy current liabilities

RATIOS INDICATING MANAGEMENT OF CURRENT ASSETS

Credit Sales How many times accounts receivable

Receivables Days In how many days accounts

Raw materials Days In how many days raw materials are

Accounts payable Average time it takes to pay its

Operating and Cash Conversion Cycles

Operating and Cash Conversion Cycles

Collect on Acquire Acquire

Operating Cycle Cash Conversion Cycle

Operating and Cash Conversion Cycles

Operating and Cash Conversion Cycles: Formulas

Net operating cycle Number of days Number of days Number of days

Over-capitalization and Working Capital

Evaluating Inventory Management

Economic Order Quantity

EOQ √2Co /Ch

Uncertainties in demand and lead times: a re-order level system

The average annual cost of such a safety inventory would be:

Average inventory = buffer safety inventory + re-order amount/2

Example 12: For the information given in Example 11,

4. Managing Accounts Receivable

Objectives in managing accounts receivable:

Evaluating the Credit function

Credit control policy

Early settlement discounts

Example 21: A company has sales of $20,000,000 p.a.

Bad debt risk

Example 26: Nelson Corporation reports the following information:

The main aspects of factoring include the following.

Criticisms of factoring include:

Managing foreign accounts receivable

5. Managing Accounts Payable

The Economics of Taking a Trade Discount

Evaluating accounts Payable Management

6. Managing the Cash Position

Examples of Cash Inflows and Outflows

Motives for holding Cash:

Cash flow forecasts (Cash Budget)

The usefulness of cash flow forecasts

Methods of easing cash shortages

Centralization of the treasury department

Possible advantages of decentralised cash management are as follows.

 Sources of finance can be diversified and can match local assets.

Cash management models

Drawbacks of the Baumol model

The Miller-Orr model

Example 38: The following data applies to a company.

7. Investing Short-term Funds

Yields on Short-Term Securities

Short-term Funds Investments

Short-term Investment Strategies

8. Managing Short-term Financing

• Uncommitted line of credit • Asset-based loan

9. Working capital investment policy

9.2 An aggressive approach