Chapter 6 - WORKING CAPITAL MANAGEMENT

Working Capital concepts

Working capital is the capital (finance) that an entity needs to support its
everyday operations. To operate a business, an entity must invest in
inventories and it must sell its goods or services on credit. Holding
inventories and selling on credit costs money. Some of the finance required
for operations is provided by taking credit from suppliers. Cash and short-
term investments are also elements of working capital. Some cash might be
held for operational use, to pay liabilities. Surplus cash in excess of
operational requirements might be invested short-term to earn some interest.
The goal of working capital management is to manage the firm’s current
assets and liabilities in such a way that a satisfactory level of working capital
is maintained.
There are two concepts of working capital: gross and net.
The term gross working capital, also referred to as working capital, means
the total current assets.
The term net working capital, can be defined in two ways (i) the most
common definition of net working capital (NWC) is the difference between
current assets and current liabilities; and (ii) alternate definition of NWC is
that portion of current assets which is financed with long term funds.
The total investment in working capital is calculated as:
Current assets:
Inventory xxx
Trade receivables xxx
Short-term investments xxx
Cash xxx
A Xxx
Minus current libilities:
Bank overdraft xxx
 Trade payables xxx
Other current liabilities xxx
B xxx
Net Working Capital (A-B) xxx

Objectives of working capital management

The management of working capital is an aspect of financial management, and
is concerned with:
 Ensuring that the investment in working capital is not excessive;
 Ensuring the level of working capital is not low (aggressive strategy)
 Ensuring that enough working capital is available to support operating
activities.
Profitability and risk: Optimal level of Current Assets
In determining a firm’s NWC position, an important consideration is the
trade-off profitability and risk. The term profitability used in this context is
measured by profits after expenses. The term risk is defined as the
probability that a firm will become technically insolvent so that it will not
be able to meet its obligations when they become due for payment.
The risk of becoming technically insolvent is measured using NWC. It is
assumed that the greater the amount of NWC, the less risk-prone the firm is,
or, the greater the NWC, the more liquid is the firm and, therefore, the less
likely it is to become technically insolvent. Conversely, the lower the levels of
NWC and liquidity are associated with increasing levels of risk. The
relationship between liquidity, NWC and risk is such that if either NWC or
liquidity increases, the firm’s risk decreases.
In evaluating the profitability –risk trade-off related to the level of NWC, two
ratios are used (i) ratio of current assets to total assets (CA/TA) and (ii) ratio
of current liabilities to total assets (CL/TA).
The CA/TA ratio indicates the percentage of CA in the total assets of a firm.
Since CA are likely to be less profitable than fixed assets, the increase in
CA/TA ratio would decrease profitability, increase liquidity (assuming no
change in CL) and reduce the risk of technical insolvency. A decrease in the
ratio will result in an increase in profitability as well as risk.
The CL/TA ratio indicates the percentage of total assets financed by current
liabilities. An increase in the ratio will yield higher profitability (due to
decrease in costs) and higher risk (due to decrease in NWC, assuming no
change in CA). The decrease in the ratio would lead to a decrease in
profitability as well as risk.
Permanent and temporary working capital
To carry on business a certain minimum level of working capital is necessary
on a continuous and uninterrupted basis. For all practical purposes, this
requirement has to be met permanently as with other fixed assets. This
requirement is referred to as permanent or fixed working capital.
Any amount over and above the permanent level of working capital is
temporary, fluctuating or variable working capital. This portion of the
required working capital is needed to meet fluctuations in demand consequent
upon changes in production and sales as a result of seasonal changes.
Financing currents assets: Short term and long term mix
Determination of financing mix is another important area of working capital
management. The financing mix refers to the proportion of current assets to
be financed by short-term sources and long term sources. It is concerned with
determination of relative share of these two broad sources in financing
current assets.
There are three approaches to determine an appropriate financing mix: (i)
hedging/matching approach, (ii) conservative approach and (iii) trade-off
between these two.
According to hedging approach long term funds should be used to finance
the permanent/core part of the current assets and the purely temporary and
seasonal requirements (over and above the permanent needs) should be met
out of short term funds. As a result current liabilities would be just equal to
seasonal current assets (NWC=0). This approach is a high profit high risk
financing mix.
According to Conservative approach, the estimated total requirements of
the current assets should be financed from long term sources. The short term
finance should be used only in emergency situations. The firm has NWC
equal to excess of long term financing over the permanent requirement. This
approach is a low profit low risk combination.
Neither the hedging nor the conservative approach is suitable for determining
an appropriate mix. A trade-off between these two extreme approaches would
give an acceptable financing strategy. One possible trade-off could be assumed
to be equal to the average of minimum and maximum requirements of funds
during a given period of time should be financed through long term and over
and above if any should be financed through short term. (26.4)
Cash Operating Cycle
An important way of assessing the adequacy of working capital and the
efficiency of working capital management is to calculate the length of the cash
operating cycle. This cycle is the average length of time between paying
suppliers for goods and services received to receiving cash from customers for
sales of finished goods or services. The cash operating cycle is linked to the
business operating cycle. A business operating cycle is the average length of
time between obtaining goods and services from suppliers to selling the
finished goods to suppliers. A cash operating cycle differs significantly for
different types of business. There are three main elements in the cash
operating cycle:
 The average length of time that inventory is held before it is used or sold.
 The average credit period taken from suppliers.
 The average length of credit period taken by (or given to) credit customers.

Cash operating cycle would be calculated as follows:

(months/days/
week)

Average inventory holding period XXX

Average trade receivable collection period XXX
XXX
Average period of credit taken from suppliers (XXX)
Operating Cash Cycle XXX
Calculation/Estimation of Working Capital
Inventory
Raw material inventory
Budgeted Cost of raw material Average inventory holding
production (in x (per unit) x period
units) (month/days/weeks/quarters)
12months/365 days/52 weeks/4quarteres
Average time for holding inventory (Inventory holding period or average
inventory days).
Average inventory days= (Average RM inventory/purchases or cost of sales) x
365 days
Work in process Inventory
Budgeted Estimated work in Average time span work-in-
production (in x process cost (per x process inventory
units) unit) (month/days/weeks/quarters)
12months/365 days/52 weeks/4quarteres
Average time span of work in process inventory/Production cycle
(Average WIP/annual cost of goods manufactured) x 365 days
Finished Goods Inventory
Budgeted Cost of goods Finished goods holding period
production (in x produced per unit x (month/days/weeks/quarters)
units) (preferably
excluding
depreciation )
12months/365 days/52 weeks/4quarteres
Finished goods holding period
(Average finished inventory/annual cost of goods sold) x 365 days
Trade receivable/Debtors
Budgeted Sales price per unit Average debt collection period
credit sales (in x or cost of sales per x (month/days/weeks/quarters)
units) unit
12months/365 days/52 weeks/4quarteres
Average time to collect (average collection period or average receivables days)
(Average trade receivables/credit sales) x 365 days

Trade creditors
Budgeted Raw material cost Credit period allowed by
yearly x per unit x creditors
production (in (month/days/weeks/quarters)
units)
12months/365 days/52 weeks/4quarteres
Average credit period allowed, average payable days
(Average trade payables/credit purchases) x 365 days
Practice Question
XYZ Ltd is planning to purchase a business and has consulted you, and one
point on which you are asked to advise them, is the average amount of working
capital which will be required in the first year.
You are given following estimates and are instructed to add 10% to your
computed figure to allow for contingencies.
Particulars Amount for the year
i- Inventory
Finished goods (3 months Rs. 20,000
holding period)
Raw material ( 4 months holding Rs 24,000
period)
ii- Credit given
Local sales (6 weeks credit) Rs. 312,000
Export sales (1.5 weeks credit) Rs. 78,000

iii- Average time lag in payment

of creditors, wages etc.
wages (1.5 weeks) Rs. 260,000
Stock & materials (1.5 months ) Rs. 48,000
Rent and royalties (6 months) Rs. 10,000
Clerical staff (.5 month) Rs. 62,400
Manager (.5 month) Rs. 4,800
Misc. expenses (1.5 months) Rs. 48,000

iv- Payments in advance

Sundry expenses (paid quarterly Rs. 8,000
in advance)

Class practice
ICAP winter 2008 Q2.
ICMA winter 2016 Q.2

Inventory management
The management of inventory is different from management of other current
assets because in this case all the functional areas are involved. The job of the
financial manager is to reconcile the conflicting viewpoints of various
functional areas regarding the appropriate inventory levels.
The objective of inventory management consists of two counterbalancing
parts (i) to minimize investment in inventory and (ii) to meet the demand for
products by efficiently organizing the production and sales operations.
Costs associated with inventory
The costs associated with inventory are:
 Purchase price of the inventory;
 Re-order costs are the costs of making orders to purchase a quantity of a
material item from a supplier. They include costs such as:
 the cost of delivery of the purchased items, if these are paid for by
the buyer;
 the costs associated with placing an order, such as the costs of
telephone calls;
 costs associated with checking the inventory after delivery from
the supplier;
 batch set up costs if the inventory is produced internally.

 Inventory holding costs:

 cost of capital tied up;
 opportunity cost of investment in inventory;
 insurance costs;
 cost of warehousing;
 obsolescence, deterioration and theft.
 Shortage/stock out costs
 lost profit on sale;
 future loss of profit due to loss of customer goodwill;
 costs due to production stoppage due to shortage of raw
materials;
Trade off
Note that there is a trade-off between holding costs and ordering costs.
Economic order quantity (EOQ)
The Economic Order Quantity model (EOQ) is a mathematical model used
to calculate the quantity of inventory to order from a supplier each time that
an order is made. The aim of the model is to identify the order quantity for
any item of inventory that minimizes total annual inventory costs.
The EOQ model formula
The order quantity or purchase quantity that minimizes the total annual cost
of ordering the item plus holding it in store is called the economic order
quantity or EOQ. Formula to calculate EOQ is as follows:
EOQ= √ 𝟐𝑿𝒂𝒏𝒏𝒖𝒂𝒍 𝒅𝒆𝒎𝒂𝒏𝒅𝑿𝒐𝒓𝒅𝒆𝒓𝒊𝒏𝒈 𝒄𝒐𝒔𝒕
Carrying cost per unit per annum

Example
A company uses the Economic Order Quantity (EOQ) model to determine the purchase
order quantities for materials.
The demand for material item M234 is 12,000 units every three months. The item costs
Rs. 80 per unit, and the annual holding cost is 6% of the purchase cost per year. The
cost of placing an order for the item is Rs. 250. What is the economic order quantity for
material item M234 (to the nearest unit)?
Example
A company uses the Economic Order Quantity (EOQ) model to determine the purchase
order quantities for materials. The demand for material item M456 is 135,000 units per
year. The item costs Rs. 100 per unit, and the annual holding cost is 5% of the purchase
cost per year. The cost of placing an order for the item is Rs. 240. What are the annual
holding costs for material item M456?

Optimum order quantity with price discounts for large orders

When the EOQ formula is used to calculate the purchase quantity, it is
assumed that the purchase cost per unit of material is a constant amount,
regardless of the order quantity.
If a supplier offers a discount on the purchase price for orders above a
certain quantity, the purchase price becomes a relevant cost. When this
situation arises, the order quantity that minimizes total costs will be either:
 the economic order quantity; or
 the minimum order quantity necessary to obtain the price discount.
The total costs each year including purchases, ordering costs and holding
costs, must be calculated for the EOQ and the minimum order quantity to
obtain each discount on offer.
Example
A company uses 245,000 units of Material X each year, which costs Rs.500
for each unit.
The cost of placing an order is Rs.5,000 for each order. The annual cost of
holding inventory each year is 10% of the purchase cost. The EOQ based on
the above information is 7,000 units. The supplier offers a price discount of
Rs. 5 per unit for orders of 10,000 units or more. Advise whether the
company should avail the discount?
Example
A company uses 120,000 units of Material X each year, which costs Rs.3 for
each unit before discount. The costs of making an order are Rs.605 for each
order. The annual cost of holding inventory is 10% of the purchase cost. The
supplier offers a price discount of Rs.0.10 per unit for orders of 25,000 up
to 40,000 units, and a discount of Rs.0.20 per unit for orders of 40,000
units or more. Find the quantity that will minimize total costs.
Inventory reorder level and other warning levels
So far, it has been assumed that when an item of materials is purchased from
a supplier, the delivery from the supplier will happen immediately. In
practice, however, there is likely to be some uncertainty about when to make
a new order for inventory in order to avoid the risk of running out of
inventory before the new order arrives from the supplier. There are two
reasons for this:
 There is a supply lead time. This is the period of time between placing
a new order with a supplier and receiving the delivery of the purchased
items. The length of this supply lead time might be uncertain and
might be several days, weeks or even months.
 The daily or weekly usage of the material might not be a constant
amount. During the supply lead time, the actual usage of the material
may be more than or less than the average usage.
In an inventory control system, if there is uncertainty about the length of the
supply lead time and demand during the lead time there might be three
warning levels for inventory, to warn management that:
 The item should now be reordered (the reorder level)
  The inventory level is too high (a maximum inventory level) or
 The inventory level is getting dangerously low (a minimum
inventory level).
Reorder level avoiding stock-outs and buffer stock
If the supply lead time (time between placing an order and receiving
delivery) is certain and demand during the lead time is constant, a
company would be able to set a reorder level such that it used the last item
just as a new order arrived thus reducing holding costs to a minimum. The
reorder level to do this is found as follows:
Reorder level – Certain lead time and constant demand=
Demand for the material item per day/week × Lead time in days/weeks
If the supply lead time is uncertain, and demand during the lead time is
also uncertain, there should be a safety level of inventory. A company may
wish to ensure that they are never out of stock. The reorder level to achieve
this is found as follows:
Reorder level: Uncertain demand in lead time=
Maximum demand for the material item per day/week x maximum supply
lead time in days/weeks.
Safety inventory (‘buffer stock’ or ‘safety stock’)
Safety stock is the difference between the reorder level based on uncertainty
and reorder level based on average consumption and certain lead time.
Safety inventory is the average amount of inventory held in excess of average
requirements Re-order level. The size of the safety inventory is calculated as
follows:
Units
Maximum usage x Maximum lead time xxx
Average usage in the lead time period:
Average demand x Average lead time (xxx)
Safety Inventory xxx
Maximum inventory level
A company will set a maximum level for inventory. Inventory held above
this would incur extra holding cost without adding any benefit to the
company. Finding this level will ensure that the company knows about the
maximum / upper bounds of stock holding cost “the worst scenario”.
Furthermore, the company will get to know the maximum space for storage
that can be asked so that it can be considered before selecting the storage
place.
When demand during the supply lead time is uncertain and the supply lead
time is also uncertain, the maximum inventory level is found as follows.
Units
Re-order level xxx
Re-order quantity xxx
Less:
Minimum demand x Minimum lead time (xxx)
xxx
Minimum inventory level
The inventory level could be dangerously low if it falls below a minimum
warning level. When inventory falls below this amount, management should
check that a new supply will be delivered before all the inventory is used up,
so that there will be no stock-out. When demand during the supply lead time
is uncertain and the supply lead time is also uncertain, the minimum
(warning) level for inventory is set as follows.
Units
Re-order level xxx
Less:
Average demand x Average lead time (xxx)
Xxx
Example:
A company uses material item AB67. The reorder quantity for this material
is 12,000 units. There is some uncertainty about the length of the lead time
between ordering more materials and receiving delivery from the supplier.
There is also some variability in weekly demand for the item.
Supply lead time (weeks)
Average 2.5
Maximum 3
Minimum 1
Demand per week (units)
Average 1,200
Maximum 1,500
Minimum 800

Calculate the reorder level, safety stock, maximum inventory level and
minimum inventory level.
An exam question might combine the EOQ model and reorder
level or safety inventory (buffer stock).
Example:
A company orders 50,000 units of an item when the inventory level falls to
100,000 units. Annual consumption of the item is 1,800,000 units per year.
The holding cost per unit is Rs.1.50 per unit per year and the cost of making
an order for delivery of the item is Rs.375 per order.
The supply lead time is 2 weeks (assume a 50-week year and constant weekly
demand for the item).
Required
Calculate the cost of the current ordering policy and calculate how much
annual savings could be obtained using the EOQ model if the existing policy
on buffer stock was retained.

Using a probability table to decide the optimal reorder level

When a company is prepared to accept the risk of stock-outs, the optimal
reorder level might be estimated using probabilities of demand (and
probabilities of the supply lead time) to calculate the reorder level that has
the lowest expected value of total cost.
A probability table can be prepared. For each possible reorder level under
consideration, we can calculate:
 The probable demand in the lead time between order and delivery;
 The risk of having excess inventory (buffer stock) and its cost;
 The risk of stock-outs and their cost (meant to be lost contribution
margin on lost sales).
There is a trade-off between stock-out cost and the holding cost associated
with the safety stock.
 A reorder level set at the maximum demand in the lead time avoids
stock out cost entirely but has the maximum level of safety stock.
 A reorder level set to meet the average demand in the lead time avoids
the holding costs associated with safety stock but will result in stock
outs.
The reorder level selected might be the reorder level at which the expected
value (EV) of cost is minimized.
Example
Company X uses a basic raw material “JKL” in its processing. It is purchased
from an external supplier.
The following information is relevant for JKL:
Holding cost Rs.12 per unit per year
Stock out cost Rs.5 for each stock-out
Lead-time 1 month
Monthly usage (demand in the lead time) varies as follows:
Units demanded during the lead time Probability
120 7%
240 8%
360 20%
480 30%
600 20%
720 8%
840 7%
Required
Find the optimal safety stock and indicate the probability of a stock out at
this level.

Class practice
ICAP Management Accounting - winter 2014 Q.1
Receivable management
When an entity sells its products to customers on credit it results in
receivable from customers. There are some benefits as well as costs
associated with giving credit.
Benefits
 Higher sales;
 Competitive edge.
Costs
 Finance cost;
 Bad debts;
 Administration costs.
Usually, a company establishes credit policy guidelines that should be
followed. The credit terms set for each customer will consist of:
 Credit period;
 Credit limit;
 Interest charges on overdue payments.
For monitoring of receivable/debtors, a regular report is prepared. This
report might be called aged debtors/receivable list or debtors/receivable
aging
Debt factors / factoring
Companies might use a factoring organization to assist with the
management of receivables and also to help with the financing of
receivables. A debt factor offers three main services to a client business:
 The administration of the client’s trade receivables;
 Credit insurance; and
 Debt finance.
Credit insurance
If the factor is given the task of trade receivables administration, it may also
agree (for an additional fee) to provide insurance against bad debts for the
client. This is known as without recourse factoring or non-recourse
factoring. If a customer of the client fails to pay an invoice that was issued
by the factor, the factor will accept the bad debt loss itself, and the factor will
pay the client the full amount of the unpaid invoice.
However, factors also provide with recourse factoring. With this type of
arrangement, if a customer of the client fails to pay an invoice, the factor will
not pay anything to the client, and the client must suffer the bad debt loss.
(If the factor has already made a payment to the client against the security
of the receivable, the client must repay the money it has received.)
Debt finance
The factor will provide advances of up to certain % of the face value of the
client’s trade receivables, for all receivables that are approved by the factor.
The finance is provided at an agreed rate of interest, and is repayable when
the customers’ invoices are eventually paid. In effect, this means that when
a customer pays the factor will remit the remaining % of the money to the
client, less the interest (and other fees). The costs of a factoring service
might therefore consist of:
 A service fee for the administration and collection of trade receivables;
 A commission charge, based on the total amount of trade receivables,
for a non-recourse factoring service; and
 Interest charges for finance advanced against the trade receivables.
For deciding about factoring all cost and benefits shall be compared.
Example:
Blue Company has annual credit sales of Rs.1, 000,000. Credit customers
take 45 days to pay. Bad debts are 2% of sales. The company finances its
trade receivables with a bank overdraft, on which interest is payable at an
annual rate of 15%.
A factor has offered to take over administration of the receivables ledger and
collections for a fee of 2.5% of the credit sales. This will be a non-recourse
factoring service. It has also guaranteed to reduce the payment period to 30
days. It will provide finance for 80% of the trade receivables, at an interest
cost of 8% per year.
Blue Company estimates that by using the factor, it will save administration
costs of Rs.8, 000 per year.
Required
What would be the effect on annual profits if Blue Company decides to use
the factor’s services? (Assume a 365-day year).
Evaluating a settlement discount
Discounts are offered to customers to settle the invoices early, discount
terms vary from customer to customer like 2/10 net 30, 4/15 net 60 etc. One
way of evaluating a settlement discount is to calculate the implied interest
cost of offering settlement discounts.
IRR of perpetuity= Constant cash flows/initial investment
Example
Entity X borrows on overdraft at an annual interest rate of 15%. Customers
are normally required to pay within 45 days. Entity X offers a 1.5% discount
if payment is made within ten days. What is the effective annual cost of
offering the settlement discount, and is the discount policy financially
justified?
An alternative method of calculating the cost of settlement discounts,
compared with a policy of not offering discounts, would be to compare the
total annual costs with each policy.

Example:
Entity X borrows on overdraft at an annual interest rate of 15%. It has
annual credit sales of Rs.5 million, and all customers buy on credit.
Customers are normally required to pay within 45 days. Entity X offers a
1.5% discount if payment is made within ten days. 60% of customers take
the discount.
What is the annual cost of the discount policy?
An exam question might combine concepts of discount, bad debts and
factoring etc.
Class practice
ICMAP Winter 2017 Q.2
Payable management
Trade credit allows the buyer to hold or make use of goods obtained from
suppliers without yet having to pay for them. It therefore postpones the need
to find the cash to make payments for goods and services purchased.
Unlike other sources of finance, including a bank overdraft or a bank loan,
trade credit does not have any cost.
However, goods are supplied on agreed credit terms. The supplier expects
to receive payment at the end of the agreed credit period.
Settlement discounts from suppliers
A supplier might offer a settlement discount for early payment. The value of
a settlement discount from a supplier should be assessed in the same way as
the cost of a settlement discount to customers. If the value of taking the
settlement discount is higher than the cost of having to finance the payment
by bank overdraft, the discount should be taken and the trade debt should
be paid at the latest time possible in order to obtain the discount.

Cash management
The objective of good cash management is to hold sufficient cash to meet
liabilities as they fall due, whilst making sure that not too much cash is held.
Money held as cash is not being invested in the wealth-creating assets of the
organization – thereby affecting profitability.
Motives for holding cash
There are several reasons why a business entity might choose to hold cash.
 To settle transactions. Cash is needed to pay expenses, and to
settle debts.
 As a precaution against unexpected requirements for cash. A
business might hold some additional cash in the event that there is a
need to make an unexpected and unforeseen payment.
 For speculative reasons. A company might hold some cash that
can be used if a business opportunity arises. Some investment
opportunities, such as the opportunity to purchase a rival business,
might require some element of cash.
  For compensating reasons. A company might keep the bank
balance sufficient to earn a return equal to the cost of free services
provided by the banks.
Objective of cash management
The basic objectives of cash management are to reconcile two mutually
contradictory and conflicting tasks: to meet the payment schedule and to
minimize funds committed to cash balance.
There are two approaches to derive an optimal cash balance: (i)cash budget
and (ii) minimizing cash cost models.
Cash budgets
A cash budget is a detailed plan of cash receipts and cash payments during
a planning period. A cash budget can be prepared by producing a table for
the cash receipts and cash payments, containing each item of cash receipt
and each item of cash payment. The cash receipts and then the cash
payments should be listed in rows of the table, and each column of the table
represents a time period, such as one month.
Cash management models
The important models are (1) Baumol model (2) Miller-Orr model and (3)
Orgler’s model.
Baumol model
Baumol model is a model that provides for cost-efficient transactional
balances and assumes that the demand for cash can be predicted with
certainty and determines the optimal conversion size/lot. The total
cost associated with cash management, according to this model, has two
elements: (i) cost of converting marketable securities into cash and (ii) the
lost opportunity.
The Baumol cash model is based on similar principles to the economic order
quantity (EOQ) model used for inventory control. It assumes that a
company spends cash regularly on expenses and that to obtain the cash it
has to sell short-term investments. The company therefore makes regular
sales of investments in order to obtain cash to pay its operational expenses.
The assumptions used in the model are as follows:
 The company uses cash at a constant rate throughout each year (the
same amount of cash every day).
 The company can replenish its cash immediately, as soon as it runs
out of the cash it has.
 Cash is replenished by selling short-term investments. These
investments earn interest. The amount of investments sold, and the
amount of cash from selling the investments, is Rs.X.
 Holding cash has a cost. This is the opportunity cost of not
investing the cash to earn interest. The opportunity cost, CH, can be
expressed as an interest rate. For example, if investments earn interest
at 4% per year, the annual cost of holding cash is 0.04.
 Selling securities or investments to obtain cash has a transaction
cost (similar to the cost of placing an order with the EOQ inventory
model). In the model, this is shown as CO.
The maximum amount of cash is therefore X and the average cash
holding is X/2.
Therefore annual cost of holding is= (X/2)*CH
If the annual demand for cash is Rs.D, the annual transaction costs of
selling securities (short-term investments) is: (D/X)*CO

Therefore as per this model, the optimal amount of cash can be obtained
using following formula:
√ 𝟐 ∗ 𝑫 ∗ 𝑪𝑶

CH
No. of conversions would be calculated as= D/X

Example
Entity KL makes payments to its creditors of Rs.3 million a year, at an
equal rate each day.
Each time it converts investments into cash, it pays transaction charges
of Rs.150.
The opportunity cost of holding cash rather than investing it is 6% per
year.
Using the Baumol model, calculate what quantity of investments should
be sold whenever more cash is needed by Entity KL.
Example-2
Entity GF invests all cash as soon as it is received, to earn interest at 5%.
It incurs cash expenditures of Rs.16,000,000 each year, and pays for
these at a constant rate each day. The cost of converting a batch of
investments into cash is Rs.250, regardless of the size of the transaction.
Required
Use the Baumol model to decide how much cash should be obtained each
time investments are sold.
Miller-Orr model
Miller-Orr model is a model that provides for cost-efficient transactional
balances and assumes uncertain cash flows and determines upper
limit and return point for cash balance.
The Miller-Orr model recognizes this uncertainty in cash flows, which are
measured statistically. Daily cash flows might be positive or negative. The
net daily cash flows are then assumed to be normally distributed around
the daily average net cash flow.
The model has a minimum cash holding. This is called the lower limit.
This is usually decided by management.
If the cash balance falls to the lower limit, then investments will be
converted into cash, to take the balance back to a predetermined amount,
known as the return point.
There is also a maximum cash holding limit, the upper limit.
The difference between the lower limit and the upper limit is called the
spread.
If the cash balance reaches the upper limit, cash is used to buy
investments. The amount of cash used to buy investments is sufficient to
return the cash balance to the return point.
The cash balance should therefore fluctuate between the upper and lower
limits, and should not exceed these limits.
 The distance between the lower limit and the return point is usually 1/3
of the total spread.
The distance between the upper limit and the return point is usually 2/3
of the total spread.
Spread=

3x[¾*transaction cost*variance of cash flows/interest rate (as

proportion)]^1/3

 The transaction cost is the cost of the sale and purchase of securities.
 The variance of cash flows is a statistical measure of the variation in the
amount of daily net cash flows. The variance should relate to the same
period of time as the interest rate. For example, if the variance is a
variance of daily cash flows, the interest rate (expressed as a
proportion) must be a daily interest rate. If in doubt, to calculate a
daily interest rate from an annual interest rate, divide the
annual interest rate by 365. Alternatively, if you prefer to be
more exact, take the 365th root (1 + interest rate), then
subtract 1 to get the daily interest rate.
 To convert an annual variance of cash flows to a daily variance, divide by
365.
 Remember also that the variance is the square of the standard
deviation (and the standard deviation is the square root of the
variance).
 A value to the power of one-third means the cube root. Make sure that
you have a calculator that can calculate a cube root.
Example
Entity ASD decides that it needs a minimum cash balance of Rs.15,000. It
estimates that it has transaction costs of Rs.50 for each purchase or sale of
short-term investments.
Based on its measured historical observations, the standard deviation of
daily cash flows is Rs.1,400.
The annual market interest rate on short-term investments is 8%.
Required
Calculate the upper cash limit and the return point using the Miller-Orr
model.
Example-2
Entity Green decides that it needs a minimum cash balance of Rs.40,000. It
estimates that it has transaction costs of Rs.120 for each purchase or sale of
short-term investments.
Based on its measured historical observations, the standard deviation of
daily cash flows is Rs.1,800.
The annual market interest rate on short-term investments is 7%.
Required
Using the Miller-Orr model, calculate the upper cash limit, and the return
point.
Other aspects of cash management
The basic strategies that can be employed to minimize the cash operating
cycle are as follows:
 Speeding up cash receipts
 Slowing down cash payments
 Effective inventory management system
 Combined cash management strategies.
Use of surplus cash: investing short term
When deciding on how to use temporary surplus cash, the following
considerations are important:
 Liquidity
 Safety
 Profitability
Short term investments
 Saving Accounts;
 Money Market investments
 Treasury bills
  Certificate of deposits
 Short term government bonds
Dealing with shortfalls of cash
Short term or long term
Various short-term sources of cash might also be available
 Bank overdraft
 Payable
 Short term bank loans
 Debt factoring
Recommended study material- ICAP CFAP-BFD (Chapter 29 to
32)

Class practice
ICAP Summer 2011 Q.2
ICAP Summer 2012 Q.6
ICAP Summer 2014 Q.2

Class practice
ICMAP

Sr. Q No. in Attempt Topic

No. paper
1. 6 May 2016 Working capital
2. 5 August 2016 Working capital
3. 2 February 2017 Estimated P&L and
working capital
4. 2 September 2017 Working capital
5. 2 August 2018 Receivable management
6. 2 February 2018 Receivable management
ICAP (Management Accounting Paper)

Sr. Q No. in Attempt Topic

No. paper
1 2 Summer 2008 Working capital
2 4 Winter 2008 Receivable Management
3 3 Summer 2016 Inventory Management
4 4 Summer 2015 Working capital
5 1 Winter 2014 Inventory management
6 2 Summer 2014 Working capital
7 1 Winter 2012 Cash flow statement
8