Chapter 10 - Working Capital Management - Cash And Funding Strategies

Question 1

Cash budgets and cash flow forecasts

Answer 1

A cash forecast is an estimate of cash receipts and payments for a future period under existing conditions.

A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the forecast into line with the overall business plan.

Question 2

Cash flow forecast from receipts and payments

Answer 2

Step 1 - Prepare a Proforma.

Step 2 - Fill in the simple figures.

• Wages and salaries.
• Fixed overhead expenses.
• Dividend payments.
• Purchase of non-current assets.

Step 3 - Work out the more complex figures.

• Timings for sales and purchases from credit periods.
• Variable overheads may require information about production levels.
• Purchase figures may require calculations based on production schedules and inventory balances.

Question 3

Cash flow forecast from a balance sheet

Answer 3

Used to predict the cash balance at the end of a given period, this method will require forecasts of:

1. Changes to non current assets (acquisitions and disposals).
2. Future inventory levels.
3. Future receivables levels.
4. Future payables levels.
5. Changes to share capital and other long term funding.
6. Changes to retained profits.

Question 4

Cash flow forecast from working capital ratios

Answer 4

Working capital ratios can also be used to forecast future cash requirements.

The first step is to use the ratios to work out the working capital requirement.

This technique is used to help forecast overall cash flow with the Proforma.

Question 5

Short term investment

Answer 5

1. Short term investment present themselves when cash surpluses arise.
2. Surplus cash comprises liquid balances held by a business which are neither needed to finance current business operations nor held permanently for short term.
3. Where balances are held temporarily for conversion to other more important business uses, absolute priority must be given to the avoidance of risk over maximising returns.

Question 6

The liquidity problem

Answer 6

If a company knows that it will need the funds in three days, it invests them for that period at the best rate available with safety. The solution is to match the maturity of the investment with the period for which the funds are surplus. The factors are:-

1. The exact duration of the surplus period is not always known. It will be known if the cash is needed to meet a loan instalment, a large tax payment or a dividend. It will not be known if the need is unidentifiable or depends on the build up of inventory, the progress of construction work or the hammering out of an acquisition deal.
2. Expected future trends in interest rates affect the maturity of investments.
3. Bridging finance may be available to bridge the gap between the time when the cash is needed and the subsequent date on investment maturity.
4. An investment may not need to be held to maturity, if an earlier withdrawal is permitted or there is a secondary market and its disposal causes no excessive loss.

Question 7

The safety problem

Answer 7

1. Safety means there is no risk of capital loss.
   For e.g. The firm should not deposit with a bank which might conceivably fail within the maturity period and thus not repay the amount deposited.
2. However safety is not necessarily defined as certainty of getting the original investment repaid at 100% of its original home currency value.
   For e.g. If the cash is held to meet a future commitment, the ultimate amount may be subject to inflationary rises and a safer investment may be an index linked gilt edged bond.

Question 8

The profitability problem

Answer 8

1. If cash is being held to meet a future payment in a foreign currency, the only risk less payment would be one denominated in that currency.

Complications:-

1. Fixed or variable rates.
   Invest long if expect interest rates to fall.
2. Term to maturity.
   Invest short or at variable rates if the rates are expected to go up.
3. Tax effects.
   Aim to optimise net cash flows after tax. Tax payments are a cash outflow.
4. Use of other currencies.
   Investing in currencies other than the company’s operating currency is incompatible except for
   - The investment is earmarked for a payment due in another currency.
   - Both principal and interest are sold forward or otherwise hedged against the operating currency.
5. Difficulty in forecasting available funds.
   Segregate receipts and payments into the following:
   - The steadier and predictable forecast able flows such as cash takings in retail trades e.g. End of the week or Christmas period.
   - The less predictable but not individually large items.
   - Controllable items such as payment to normal suppliers.
   - Items such as collections from major customers.
6. Difficulty in finding the most favourable rates.
   Know the benefits and available instruments. Shop around for the best buy among investees.

Question 9

Bank overdrafts

Answer 9

1. Mainly provided by the clearing banks and represent permission by the bank to write cheques even though the firm has sufficient funds in the account.
2. An overdraft limit will be placed and provided the limit is not exceeded, the firm can use as little or as much as it desires.

Advantages:-

1. Flexibility
2. Cheapness - Usually 2-5% above base rate.

Disadvantages:-

1. Overdrafts are legally payable on demand.
2. Security usually required by way of fixed or floating charges on assets or private guarantees from owners.
3. Interest costs vary with bank base rates.

Question 10

Bank loans

Answer 10

1. A bank loan represents a formal agreement between the bank and the borrower. The bank will lend a specific sum for a specific period and interest is paid on this sum.
2. Therefore this is likely to be more expensive than the overdraft and is less flexible but there is no danger the source will be withdrawn before the expiry of the loan period.

Question 11

The attitude of management to risk: aggressive, conservative and matching funding policies.

Answer 11

Aggressive - Finance most current assets, including ‘permanent’ ones with short term finance. Risky but profitable.

Conservative - Long term finance is used for most current assets including a proportion of fluctuating current assets. Stable but expensive.

Matching - The duration of the finance is matched to the duration of the investment.

Question 12

Reasons for holding cash

Answer 12

1. Transactions motive - Cash required to meet day to day expenses.
2. Precautionary motive - Cash held to give a cushion against unplanned expenditure.
3. Speculative motive - Cash kept available to take advantage of market investment opportunities.

The cost of running out of cash depends on the firms particular circumstances but may include not being able to pay debts as they fall due which can have serious operational repercussions.

1. Trade suppliers refuse to offer further credit, charge higher prices or downgrade the priority with which orders are processed.
2. If wages are not paid on time, industrial action may result, damage production in the short term and relationships and motivation in the medium term.
3. The court may be petitioned to wind up the company if it consistently fails to pay bills as they fall due.