Lecture 4 Flashcards
What is working capital management?
- It is defined as the current assets and current liabilities
- net working capital = a measure of working capital
- NWC = Cash + Cash equivalents - Current Liabilities
What is current assets management
Current assets management focuses on the size of a firms investments in current assets
Current Asset Management (Flexible Policies)
- Keeping large balances of cash and marketable securities
- Making large investments in inventory
- Granting liberal credit terms, which results in a high level of accounts Recievable
Current Asset Management (restrictive policies)
- Keeping low balances of cash and marketable securities
- Making small investments in inventory
- Allowing no credit sales and no accounts recievable
What is current liability management?
Focuses on how to finance the current assets or how to cover the current asset requirement.
Current Liability Management (flexible policies)
- Long term financing covers more than the total asset requirement
Current Liability Management (restrictive policies)
- long term financing doesn’t cover more than total asset requirements so short term borrowing is needed
What is cash management?
- Concerns on finding optimal cash balance to ensure collecting and disbursing cash effectively.
Reasons for a firm to hold cash
- Transactional motive - as if inflows and outflows are not synchronised some cash is needed at the bank to act as a buffer
- Compensating balance - cash is held at the bank to compensate for banking services rendered to the firm
Costs of holding cash
- Opportunity cost - if balance is too high loss of interest/ potential returns from other projects
- Transaction costs - if balance is too low the firm has to sell securities which incurs a transaction cost
The Baumol Model
An application of a simple inventory model to cash balance. It is under the assumption of keeping a cash reservoir, which is steadily drawn down to disburse. When cash runs out replenish it by selling short term securities of borrowing.
Baumol Model (limitation and assumptions)
Limitations
- No taxes
Assumptions
- Ignores taxes
- Firms are likely to hold a buffer level of cash rather than let it depelinish to zero
- Unrealistic assumption that cash balance decreases at a constant rate
- Not flexible to change of parameters
Miller-Orr Model
A more elaborate model that offers a nice compromise between simplicity and realism. It allows for cash inflows and outflows that a firm cannot predict at a daily level.
Miller-Orr (Limitations)
- Ignores taxation
- Daily Cash flow is difficult to predict
- Not flexible to change of parameters
- Setting the lower control limit is depending on the firms risk preference
- Empirical evidence suggests that the performance of the model is not outstanding
What is a float and why does it exist?
A firms cash balance is reported in the financial statement is not always the same as the cash balance in the bank. This is due to cheques that have been paid in but aren’t yet cleared. The difference between bank cash and book cash is called the float.
