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Notes: Introduction To Working Capital

This document provides an overview of working capital management. It defines key terms like net working capital, current assets, and current liabilities. It discusses the risk-return tradeoff of investing in current assets versus borrowing through current liabilities. It also covers objectives of cash management like minimizing insolvency risk and reducing idle cash balances. Finally, it summarizes various cash collection and disbursement procedures like lockboxes and preauthorized checks that can accelerate cash receipts and improve cash flow.

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0% found this document useful (0 votes)
63 views5 pages

Notes: Introduction To Working Capital

This document provides an overview of working capital management. It defines key terms like net working capital, current assets, and current liabilities. It discusses the risk-return tradeoff of investing in current assets versus borrowing through current liabilities. It also covers objectives of cash management like minimizing insolvency risk and reducing idle cash balances. Finally, it summarizes various cash collection and disbursement procedures like lockboxes and preauthorized checks that can accelerate cash receipts and improve cash flow.

Uploaded by

anugp
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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NOTES

INTRODUCTION TO WORKING CAPITAL

 Net working capital = current assets – current liabilities.


 Current assets are marketable securities, cash, accounts receivable, inventories.

 Current liabilities are short term loans and debt.


 By managing the working capital of a firm, we are talking about managing the firm’s

liquidity.
 There’s always a ‘Risk-Return Tradeoff’. Investing in current assets gives lesser returns

but also risk is reduced regarding illiquidity. Similarly, borrowing from short term loans
is beneficial as they levy lower interest rates but then, increase in current liabilities also
decrease the net working capital increasing the risk of illiquidity.
 Other things remaining the same, the greater a company’s reliance upon short term

debt or current liabilities in financing its asset investments, the lower will be its liquidity.
 Hedging principle states that the financing maturity follows the cash-flow-producing

characteristics of the asset being financed.


 Sources of financing constitute temporary, permanent and spontaneous sources.
Temporary sources of financing consist of current liabilities. (Short term notes payable)
Permanent sources of financing include intermediate term-loans, long-term debt,
preferred stock, common equity.
Spontaneous sources of financing consist of trade credit and other accounts payable
that arise spontaneously in the firm’s day-to-day operations. Some more spontaneous
sources of financing are wages and salaries payable, accrued interest and accrued taxes.
CASH AND MARKETABLE SECURITIES MANAGEMENT

 Holding too much cash, i.e. excess cash, results in a profitability loss the firm.
 Marketable securities are those securities that a firm can quickly convert into cash
balances. Also referred to as near cash or near cash assets.
 Motives for holding cash:
The transactions motive, the precautionary motive, the speculative motive
 Transactions motive – it allows the firm to dispense with cash needs that arise in the
ordinary course of doing business.
 Precautionary motive – this relates to the maintenance of balances to be used to satisfy
possible, but as yet indefinite, needs. It is met to a large extent by the holding of a
portfolio of liquid assets, not just cash.
 Speculative motive – cash is held for speculative purposes in order to take advantage of
hoped for profit-making situations. Generally it’s the least important component of a
firm’s preference for liquidity.
 The transactions and precautionary motives account for most of the reasons why a
company holds cash balances.

CASH MANAGEMENT OBJECTIVES AND DECISIONS

 A companywide cash management program must be concerned with minimizing the risk
of insolvency.
 A situation in which the firm is unable to meet its maturing liabilities in time is called
insolvency.
 The company is technically insolvent when it lacks the necessary liquidity to make
prompt payment on its current debt obligations.
 The risk-return tradeoff can be reduced to two prime objectives for the firm’s cash-
management system:
Enough cash should be on hand to meet the disbursal needs that arise in the course of
doing business.
Investment in idle cash balancers must be reduced to a minimum.
 Two conditions would allow the firm to operate for extended periods with cash balances
near or at a level of zero:
A complete accurate forecast of net cash flows over the planning horizon
Perfect synchronization of cash receipts and disbursements

COLLECTION AND DISBURSEMENT PROCEDURES

 The efficiency of the firm’s cash management program can be enhanced by knowledge
and use of various procedures aimed at:
Accelerating cash receipts
Improving the methods used to disburse cash.
 The reduction of the float lies at the center of the many approaches employed to speed
up cash receipts. Float has four elements as follows:
1. Mail float is caused by the time lapse from the moment a customer mails a
remittance check until the firm begins to process it.
2. Processing float is caused by the time required for the firm to process remittance
checks before they can be deposited in the bank.
3. Transit float is caused by the time necessary for a deposited check to clear through
the commercial banking system.
4. Disbursing float derives from the fact that funds are available in the company’s bank
account until its payment check has cleared through the banking system.

The Lock-Box Arrangement

 The most widely used commercial banking service for expediting cash gathering. Banks
have offered this service since 1946. Such a system speeds up the conversion of receipts
into usable funds by reducing both mail and processing float. In addition, it is possible to
reduce transit float if lock boxes are located near Federal Reserve Banks and their
branches. For large corporations that receive checks from all parts of the country, float
reductions of two to four days are not unusual.
In summary, the benefits of a lock-box arrangement are these:
1. Increased working cash
2. Elimination of clerical functions
3. Early knowledge of dishonored checks

Preauthorized Checks (PAC)

For some firms the use of PACs can even be more effective way of converting receipts into
working cash. A PAC resembles the ordinary check, but it does not contain nor require the
signature of the person on whose account it is being drawn. A PAC is created only with the
individual’s legal authorization.

 The PAC system is advantageous when the firm regularly receives a large volume of
payments of a fixed amount from the same customers.
 This type of cash management service has proved useful to insurance companies,
savings and loan associations, consumer credit firms, leasing enterprises, and charitable
and religious organizations.
 The objective of the system is to reduce both mail and processing float.

The benefits are:

1. Highly predictable cash flows


2. Reduced expenses
3. Customer preference
4. Increased working cash
Payable Through Drafts

 These are legal instruments that have the physical appearance of ordinary checks but
are not drawn on a bank.
 Instead these are drawn on and payment is authorized y the issuing firm against its
demand deposit account.
 Like checks, the drafts are cleared through he banking system and are presented to the
issuing firm’s bank.
 The bank serves as a collection point and passes the drafts on to the firm. The corporate
issuer usually has to return by the following business day all drafts it does not wish to
cover.

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