FINANCE IN A CANADIAN

SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
 CHAPTER
TWENTY-TWO

Cash and Working Capital

Management
 Learning Objectives

1. Explain why the efficient utilization of

working capital is so important for companies.
2. Define the difference between short-term
and long-term financing.
3. Identify the four motives that influence the
proportion of a company’s assets to be held
in cash.
 Learning Objectives

4. Discuss the circular flow of funds in a

business and the role of the various types of
expenses and incomes.
5. Describe the types of inflows and outflows in
a cash budget and how they interact.
 Introduction
 Working capital – encompasses both a
firm’s current assets and current liabilities
 Net working Capital – the difference
between current assets and current
liabilities
 In this chapter we look at:
 the general concepts that guide a firm’s
investment in current assets
 the management of cash and marketable
securities
 General Concepts of
Working Capital Management
 Efficient management of working capital is
vital to the success of the firm
 Different industries require different levels of
working capital
 Factors important to the management of
corporate liquidity include:
 good cash flow management
 maintaining adequate earnings
 good relations with bankers
 proper management of receivables,
inventories, and capital expenditures
 General Concepts of
Working Capital Management
 General Concepts of
Working Capital Management
 Warning signs indicating potential liquidity
problems:
 a buildup of inventories and declining inventory
turnover
 increases in debt and debt ratios
 increases in costs that cannot be passed on
 increases in accounts receivables and collection
periods
 a decline in net working capital and daily cash
flows
 General Concepts of
Working Capital Management
 Investment in current assets
 current assets tend to grow as sales
increase
 a firm should increase current assets until
the marginal benefit from investment
equals marginal costs of
carrying the additional
assets
 General Concepts of
Working Capital Management
Optimal Investment in Inventory:
Marginal Benefits Equal Marginal Costs
 General Concepts of
Working Capital Management
 The use of short-term liabilities
 Firms may draw on short-term liabilities to
finance their operations for three reasons:
1. funds may be needed only temporarily
 common for seasonal businesses
2. debt with shorter maturities is often cheaper
and easier to obtain than long-term debt
3. long-term financing requires a large amount
to be raised at one time
 General Concepts of
Working Capital Management
 General Concepts of
Working Capital Management
 Interest rate advantages
 Firms perceive an incentive to carry short-
term debt over long-term debt because it
is cheaper
 risks in financing with short-term debt
include:
 short-term debt has to rolled over continually
 unpredictable future interest rates
 availability of funds can change
 General Concepts of
Working Capital Management
 Stop-gap financing
 commonly used as a bridge while
preparing for long-term financing
 International consideration
 foreign exchange exposure and the affect
on current assets and liabilities must be
considered for firms operating
internationally
 Cash Management
 Cash management is concerned with determining
the cash balances that will adequately sustain
the operation of the company
 Proper cash management is crucial to the well-
being of any corporation
 Profitability and liquidity are important when
dealing with cash management
 Profitability – when a firm’s revenues exceed the costs
incurred in producing the revenues
 Liquidity – when a firm can meet its obligations as
they come due
 Motives for Holding Cash
 Motives for holding cash include:
 Transaction motive – looks at holding cash to
meet current transactions
 Precautionary motive – focuses on cash
balances that are held to provide a cushion for
unexpected events such as business declines
 Speculative motive – arises when cash is held
to take advantage of situations such as sudden
price declines or increases in interest rates
 Finance motive – deals with the buildup of
funds required to finance capital budget
appropriations
 Flow of Funds
Typical Flow of Funds through a Business
 Cash Budgeting
 Cash Budget
 a forecast of all cash flows into and out of the firm
over a given time period
 budget time periods can be:
 year-to-year
 month-to-month
 week-to-week
 daily
 useful for short-term forecasting, external financing,
or the temporary investment of excess funds
 required by banks as part of loan applications
 Managing Cash Flow
 Managing cash flows
 to ensure that inflows are received as soon as
possible and that payments are not made any
sooner than necessary, in order to maximize the
firms available cash.
 Steps in speeding up collection time include:
 prompt invoicing
 efficient handling of receipts

 Float – the time that elapses from the initial

mailing until the funds are available to the
recipient
 Managing Cash Flow
 Two techniques used to reduce mail float include:
 Concentration banking – customers are instructed
to make payments to the firm’s closest office, which
deposits collection into a local branch bank account
 lock boxes – firms establish local, locked post office
boxes that customers use as mailing addresses for
payments. The local bank is authorized to empty
and deposit the funds into the firm’s account
 Pre-authorized payment service can be used to
eliminate mail floats through a bank automatically
debiting a customer’s account on the payment date
 Optimal Cash Balance

 Optimizing cash balances

 important for large corporations
 when firms hold cash they are faced with
an opportunity cost
 the optimal cash balance is one where the
marginal benefits from holding additional
cash equals the marginal opportunity costs
 firms face precautionary motive related to
ensuring the firm has sufficient liquidity in
an unpredictable environment
 Optimal Cash Balance
 Investment in marketable securities
 Excess funds are usually invested in short-
term securities that limit risk and are liquid
 Factors to consider when investing temporary
cash balances
1. The amount to be invested and the period over
which the funds are available for investment
should be large enough to cover transaction costs
2. The choice of securities
3. The balance between cash holdings and
marketable securities needs to be determined
based on returns and transaction costs
 Summary

1. Efficient utilization of working capital is

important due to the effects on
profitability and liquidity of a firm.
Conceptually, the optimal levels of
investment in current assets occur
when marginal costs equal marginal
benefits.
 Summary

2. The use of short-term liabilities is

primarily used to satisfy temporary,
seasonal needs. Short-term funding
may act as a stop-gap measure while
temporarily postponing long-term
financing, or while waiting for
requirements to have grown sufficiently
to warrant a public issue of long-term
securities.
 Summary

3. Cash management is concerned with

determining the optimal cash balances
that a business should carry. The
proportion of assets that a firm should
maintain in cash derives from the
imposition of the transaction motive,
the precautionary motive, the
speculative motive, and the finance
motive on each other.
 Summary

4. The flow of funds in a business can be

depicted as a circular movement. Funds
are committed to expenses of operations,
purchases of fixed assets, servicing of
outstanding capital, and payment of taxes.
As sales are generated and accounts
receivable collected, funds flow back to
replenish the pool. Investment in
inventories and accounts receivable result
in time lags in the flow of funds.
 Summary

5. A cash budget is a detailed plan that lays out

projected cash inflows and outflows over a
given period. The cumulative net flow
determines the cash balance that will be
available, or the amount of borrowing that
will have to take place.
6. Excess balances of cash may be invested
temporarily in marketable securities.
Anticipated returns should exceed transaction
and management costs.