1、1Paper F9Financial Management Accounting School 2Working capital financeChapter 63Topic listThe management of cashCash flow forecastsTreasury managementCash management modelsInvesting surplus cashWorking capital funding strategies4Exam guideThe material covered in this chapter is highly examinable.A
2、ny of the calculation could form part or all of a question and you need to also be able to explain the meaning of your answers.51 The management of cashThe termCash may be defined as currency held by the firm plus the firms demand deposits Cash,which can be broadly defined as encompassing near-cash
3、such as marketable securities and unused short-term borrowing capacity,may be held for various reason Marketable securities are defined as short-term,highly liquid,interest-bearing financial assets,such as Treasury bills or high-grade commercial paper61.1 Why organization hold cash(Motives for holdi
4、ng cash)Transaction motive to meet current transactions(paying its A/P,employees wages,tax;dividend)Precautionary motive this means that there is a need to maintain a buffer of cash for unforeseen contingencies.The more predictable the inflows and outflows of cash for a firm,the less cash that needs
5、 to be held for precautionary motive need.Ready borrowing power(overdrafts)Speculative motive take advantage of special situations(sale price on raw material buy more now)71.1 Why organization hold cash(Motives for holding cash)Cash management involves:determining the cash balances that will adequat
6、ely sustain the firms operationefficient payment and collection investing temporary surplus funds in liquid assets.objectives:reduce the opportunity cost of holding idle cash(invest in ST marketable securities)ensure all obligations are paid on time/due date(not early)collect money owed as soon as i
7、t becomes due 8The cash Management ActivityShort-Term financing strategies for cash shortagesMarketable security investment strategies for cash surplusesEstablishing an optimal cash balanceManagement of cash flowCash budgetingSpeeding up receiptsSlowing down disbursementsMaintaining sound banking re
8、lationship9Flow of fundsMarketable securitiesCash balanceReceivableInventoryFixed assetsDepreciationCredit salespurchaseLabor and materialpurchase sale sale cash sales collectionsCreditors ShareholdersCreditors Shareholders Governments101.1 Why organization hold cashliquidity v profitabilityProfitab
9、ility varies inversely with liquidity.Increased liquidity generally comes at the expense of reduced profitability.There is a trade-off between liquidity with profitability111.2 Cash flow problemsMaking lossesInflation GrowthSeasonal businessOne-off items of expenditure122 Cash flow forecastsFast for
10、wardCash flow forecasts show the expected receipts and payments during a forecast period and are a vital management control tool,especially during times of recession.Key term a cash flow forecast is a detailed forecast of cash inflows and outflows incorporating both revenues and capital items.13 2 C
11、ash flow forecastsCash receiptsCash disbursementsNet cash flowCash shortfalls and surpluses Beginning cash balance +Net cash flow=Ending cash balance Minimum cash balanceShort-term financing required or repayment(minimum cash balance minus ending cash balance).Or Investment or purchase at marketable
12、 securities(ending cash balance-minimum cash balance)142.1 The usefulness of cash flow forecasts One of the most important planning toolsGiving management an indication of potential problems that could arise and allows them the opportunity to take action to avoid such problems.152.1 The usefulness o
13、f cash flow forecasts Management will need to take appropriate action depending on the potential positionCash positionAppropriate management actionShort term surplusPay A/P early to obtain discount;Attempt to increase sales by increasing A/R and inventories;Make short term inventionShort term defici
14、tIncrease A/P;Reduce A/R;Arrange an overdraftlong term surplusMake long term investment;expand;diversify;Update/replace non-current assetsLong term deficitRaising long term financeConsider shutdown/disinvestment opportunities 162.2 what to include in a cash flow forecast A cash flow forecast is prep
15、ared to show the expected receipts,and payments of cash during a budget period.Profit v cash flowNot all cash flow receipts affect income statement income.Not all cash payment affect income statement expenditureSome costs in the income statement such as profit or loss on sales of non-current assets
16、or depreciation are not cash items but are costs derived from accounting conventionsThe timing of cash receipts and payments may not coincide with the recording of income statement transactions.To ensure that there is sufficient cash in hand to cope adequately with planned activities,management shou
17、ld prepare and pay close attention to a cash flow forecast rather than a income statement.172.6 Method of easing cash shortages Fast forwardCash shortage can be eased by postponing capital expenditure,selling assets taking longer to pay A/P and pressing A/R for earlier payment.182.6 Method of easing
18、 cash shortages Measures Postponing capital expenditureAccelerating cash inflowsReversing past investment decisions by selling assets previously acquiredNegotiating a reduction in cash outflows,to postpone or reduce payment.Longer creditLoan repaymentsDeferral corporate taxReducing dividend payment1
19、92.7 Deviations from expected cash flow A cash flow forecast modelSensitivityProbability distribution 20Board of directorsChief Executive officerVice president operationsVice president marketingChief finance offerControllersCost accountingCost management Data processingGeneral processingInternal con
20、trolPreparing financial statementsPreparing budgetsPreparing forecastTreasurerCapital budgetCash managementCredit managementDividend disbursementFinance analysis&planningInvestor relationPensions managementRisk management213 Treasury management Fast forwardA large organization will have a treasury d
21、epartment to manage liquidity,short term investment,borrowings,foreign exchange risk and other,specialized,areas such as forward contracts and future etc.Key termTreasury management can be defined as:the corporate handing of all financial matters,the generation of external and internal funds for bus
22、iness,the management of currencies and cash flows and the complex strategies,policies and procedure of finance.223.1 Centralization on the treasury department Advantage of centralization:Centralized liquidity managementAvoid having a mix of cash surpluses and overdrafts in different localized bank a
23、ccountsFacilitates bull cash flows,so that lower bank charges can be negotiated.Larger volumes of cash flow are available to invest,giving better short term investment opportunity.Any borrowing can be arranged in bulk,at lower interest rates than for smaller borrowings,and perhaps on the Eurocurrenc
24、y or Eurobond markets.233.1 Centralization on the treasury department Advantage of centralization:Foreign risk management is likely to be improved in a group of company.Employing expertsReducing the cash need of precautionary purpose.Through having a separate profit centre,attention will be focused
25、on the contribution to group profit performance that can be achieved by good cash,funding,investment and foreign currency management.243.1 Centralization on the treasury department Advantage of decentralized:Source of finance can be diversified and can match local assets.Greater autonomyMore respons
26、iveMore limited opportunities to invest such balances on a short term basis.254 Cash management modelsFast forwardOptimum cash holding levels can be calculated from formal models,such as the Baumol model and Miller-Orr model.Cash management models attempt to minimizing the total costs associated wit
27、h cash movements between a current account and short term investment the opportunity cost of lost interest plus transaction costs-by determining when,and how much,cash flow should be transferred each time.264.1 The Baumol modelThe Baumol model assumes that cash is steadily consumed over time and a f
28、irm holds a stock of marketable securities that can be sold when cash is needed.The cost of holding cash is the opportunity cost,i.e.foregone from not investing that cash.The cost of placing an order is the administration(conversion)cost incurred when selling the securities.icashholdingoft2QcosCtdtr
29、ansferreQScosCQSittotal2QcosiSCQ2274.1 The Baumol modelDrawbacks of the Baumol modelIn reality,it is unlikely to be possible to predict amounts required over future period with much certainty.No buffer inventory of cash is allowed for.There may be costs associated with running out of cash.There may
30、be other normal costs of holding cost which increase with the average amount held.The problem with the Maumol model is its unrealistic assumption that firms face a constant demand for cash.284.2 The Miller-Orr modelCash balanceThe firm buys securitiesThe firm sells securitiestimeABUpper limitReturn
31、pointLower limit The Miller-Orr model controls irregular movements of cash by uses of upper and lower limits on cash balance.294.2 The Miller-Orr modelThe formula of Miller-Orr modelWhere transaction costs=transferred costs for each buying and selling securities variance of cash flow=expected daily
32、variance of cash flow balance interest rate=daily interest rate of security31intvarcos433rateerestcashflowsofiancettranactionspread)31(limintspreaditlowerporeturn305 Investing surplus cash Fast forwardTemporary surpluses of cash can be invested in a variety of financial instruments.Long term surplus
33、es should be returned to shareholders if there is a lack of investment opportunities.315 Investing surplus cash The objectives of investing surplus cashLiquidity:the cash must be available for use when neededSafety:no risk of capital loss must be takenProfitability:subject to the above,the aim is to
34、 earn the highest possible after tax returns.325 Investing surplus cash Other factors needed to be considered:fixed or floating interest ratesTerm to maturity Marketability Minimum amountWhether to invest on international markets 335 Investing surplus cash Surplus cash lack of investment opportunity
35、 may be returned to shareholders by:increasing the usual level of the annual dividendMaking a one-off special dividend paymentBuying back its own shares 345.1 short term investments Deposit Bank depositMoney market lendingLocal authority depositFinance house depositsShort term debt instrumentCertifi
36、cate of depositsTreasury billsLonger term debt instrumentShare of listed companies355.1 short term investmentsCertificates of depositsA CD is a security that is issued by a bank,acknowledging that a certain amount of money has been deposited with it for a certain period of time(usually,a short term)
37、CDs are negotiable and traded on the CD market(a money market),so if a CD holder wishes to obtain immediate cash,he can sell the CD on the market at any time.Treasury billsTreasury bills are issued weekly by the government to finance short term cash deficiencies in the governments expenditure progra
38、m.Treasury bills have a term of 91 days to maturity,after which the holder is paid full value of the bill.366 Working capital funding strategies Fast forwardWorking capital can be funded by a mixture of short and long term funding.Business should be aware of the distinction between fluctuating and p
39、ermanent assets.376.1 The working capital requirement Working capital(over a one year period)=current assets current liabilities386.3 The level of working capitalA conservative approachA conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels
40、 of working capital.The cumulative effect on these policies can be that the firm carries a high burden of unproductive assets,resulting a financing cost that can destroy profitability.A period of rapid expansion may also cause severe cash flow problems as working capital requirements outstrip availa
41、ble finance.Further problems may arise from inventory obsolescence and lack of flexibility to customer demands.396.3 The level of working capitalAn aggressive approachAn aggressive working capital management policy aims to reduce this financing cost and increase profitability by cutting inventories,
42、speeding up collection from customer,and delaying payment 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.406.3 The level of working capitalAn moderate approachA
43、n moderate working capital management policy is a middle way between the aggressive and conservative approaches.uThe decision regarding the level of overall investment in working capital is a risk/return trade-off:-liquidity v profitability;-profitability v riskLiquidity-the ability of an asset to b
44、e converted into cash without a significant price concession416.3 The level of working capitalliquidity v profitabilityProfitability varies inversely with liquidity.Increased liquidity generally comes at the expense of reduced profitability.profitability v riskProfitability moves together with risk(
45、i.e.there is a trade-off between risk and return).In search of higher profitability,we must expect to take greater risks.426.3 The level of working capitalCurrent assetsPolicy APolicy BPolicy CAsset levelOutput unit0436.3 The level of working capitalassestsfixedinvertoryreceivablecashprofitNetassets
46、totalprofitNetROI)(446.4 Permanent and fluctuating current assetsNon-current(fixed)assets are long term assets from which an organization expects to derive benefit over a number of periodsPermanent current asset are the amount required to meet long term minimum needs and sustain normal trading activ
47、ity.Fluctuating current assets are the current assets which vary according to normal business activity.For example due to seasonal variations.456.4 Permanent and fluctuating current assetsPermanent current asset together with Fluctuating current assets form part of the working capital of the busines
48、s,which may be financed by either long term funding or by current liabilities(short term funding)466.5 Working capital financingShort term sources of funding are usually cheaper and more flexible than long term.However short term sources are riskier as interest rates are more volatile in the short t
49、erm and they may be not be renewed.47Links between long-term and short-term financing decisionsShort-term debtLong-term debtEquity Liquidity risk costs higher lower lower middle no higher48Spontaneous,Temporary,and Permanent sources of FinancingSpontaneous financing-Trade credit,and other payables a
50、nd accruals,that arises spontaneously in the firms day-to-day operations.Spontaneous current liabilities required at the seasonal low are called the spontaneous permanent liabilities.The difference between the highest level of current liabilities and the spontaneous permanent liabilities is called t
