Part C

ACCA – APPLIED SKILLS
FINANCIAL MANAGEMENT
BISC TRAINING CENTER
Mr. Ha Long Giang, ACCA, CPA
Ms. Pham Mai Anh, ACCA, MSc
www.bisc.edu.vn
085 8822 168
[email protected]
Part C
Working Capital Management
Chapter 4
Working Capital
Hockiemtoanonline.edu.vn 2
1
Chapter 4 – Main parts
Part 1. The nature of Working Capital
Part 2. Objectives of Working Capital management
Part 3. The Cash Operating Cycle
Part 4. Working Capital ratios
Part 5. Over-Capitalization vs Overtrading
The nature of Working Capital
Definition
Working capital is the net current assets which are available for
day‐to‐day operating activities.
Investment in Working Capital = Inventory + Receivables – Payables
2
Objective of
Objectives of Working Capital
Profitability is to maximize the shareholder’s wealth
Liquidity is to ensure that business is able to pay of its liabilities.
Liquidity Vs Profitability
If we maintain more liquid assets, profitability will be reduced.
If we maintain less liquid assets, profitability will be increased as more
assets are invested but risk of insolvency increased
 There is always a CONFLICT between liquidity and profitability.

 Good WORKING CAPITAL MANAGEMENT is to achieve a
balance between these objectives
Objective of
WORKING CURRENT CURRENT
CAPITAL = ASSETS ─ LIABILITY
Trade
Working Capital Cycle Inventory Cash Trade Payable
Receivable
Working capital ratio

EOQ Managing AR CF forecast Managing AP
(Liquidity Ratios)
Cash
Over Managing Early payment
Capitalisation
Over trading Re‐oder level management
foreign AR discount
model
Maximum Early
WC Investment
inventory settlement Baumol model Trade Credit
Policy
level discount
Conservative Aggressive Miler – Orr

approach approach Buffer level Factoring
model
WC Finace Invoice Investing

JIT
Policy discounting surplus cash
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The Cash operating cycle
• The cash operating cycle (WC cycle, trading cycle, cash conversion
cycle) is the period of time which elapses between the point at which
cash begins to be expended on the production of a product and the
collection of cash from a purchaser
Payables
Cash
Collections Cash Operating cycle =
Purchases The average time that raw
materials remain in inventory
RECEIVABLES ─ the period of credit taken from
RAW MATERIALS
suppliers
+ the time taken to produce the
Sales
goods
Production
+ the time taken by customers
to pay for the goods
FINISHED GOODS
WORK IN PROGRESS
Production
EXAMPLE:
Wines Co buys raw materials from suppliers that allow Wines 2.5 months
credit. The raw materials remain in inventory for one month, and it takes
Wines 2 months to produce the goods. The goods are sold within a couple of
days of production being completed and customers take on average 1.5
months to pay.
Required
Calculate Wines's cash operating cycle.
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HOW TO REDUCE CASH OPERATING CYCLE TIME:
• Improving production efficiency

• Improving finished goods and / or raw material inventory turnover
• Improving receivable collection and payables payment periods.
Working Capital Ratios

• Working capital ratios may help to indicate whether a
company is over-capitalised, with excessive working capital, or
if a business is likely to fail
Working capital ratios can be classified into:
 Solvency/Liquidity ratio:
• Current ratio
• Quick ratio
 Turnover ratio:
• The accounts receivable payment period
• The accounts payable payment period
• The inventory turnover period
 The sale revenue/net working capital ratio
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Liquidity Ratio
Current Assets
Current Ratio =
Current Liabilities
Current Assets − Inventories

Quick Ratio or Acid Test Ratio =
Current Liabilities

Turnover Ratio
The account receivable payment period
Accounts receivable days or accounts receivable payment period, or
Trade receivables
Average collection period = x 365 days
Credit sales
This is a rough measure of the average length of time it takes for a
company's accounts receivable to pay what they owe.
Credit sales
Account receivable turnover = times
Trade receivables
The estimate of accounts receivable days is only approximate.
• The statement of financial position value of accounts receivable might
be abnormally high or low compared with the 'normal' level the
company usually has. This may apply especially to smaller companies,
where the size of year‐end accounts receivable may largely depend on
whether a few or even a single large customer pay just before or just
after the year‐end.
• Turnover in the income statement excludes sales tax, but the accounts
receivable figure in the statement of financial position includes sales
tax. We are not strictly comparing like with like.
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Turnover Ratio
The account payable payment period
Average trade payables

Accounts payable payment period = x 365 days
Purchases or Cost of sales
• The accounts payable payment period often helps to assess a

company's liquidity
• It indicates the average number of days that the company
take to pay suppliers

Turnover Ratio
The inventory turnover period
Cost of sales
Inventory turnover = times
Average inventory
The inventory turnover period can also be calculated in days:
Average inventory
Inventory turnover period (finished goods) = x 365 days
Cost of sales
Average raw materials inventory

Raw materials inventory holding period = x 365 days
Annual purchases
Average WIP
Average production (work−in−progress) period = x 365 days
Cost of sales x % of completion
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The sale revenue/Net working capital ratio
Sales revenue
The ratio =
Current assets – Current liabilities
• Working capital must increase in line with sales to avoid liquidity problems
• This ratio can be used to forecast the level of working capital needed for a
projected level of sales
Note:
Generally closing balances will be considered as average balances.
If not mentioned, all the sales and purchases are considered to be on credit.
In the absence of purchases, Cost of sales will be used.
If not given, all inventory will be considered as finished goods
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PRACTICE 1:
The following has been calculated for BB Co:
Receivables days: 58
Inventory turnover: 10 times per annum
Payables days: 45
Non‐current asset days: 36
What is the length of the cash operating cycle?
A. 23 days
B. 49.5 days
C. 85.5 days
D. 139.5 days

PRACTICE 2:
WW Co has a current ratio of 2. Receivables are $3m and current liabilities
are $2m.
What are inventory days if cost of sales is $10m per annum and WW Co has
a zero cash balance? Assume a 365 day year.
A. 36.5 days
B. 91.25 days
C. 14.6 days
D. 243.3 days
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PRACTICE 3:
MM Co sells some inventory on credit for a profit.
All else being equal, what will happen to the quick and current ratio after
this sale?
Quick Current
A. Increase Decrease
B. No change Increase
C. Increase No change
D. Increase Increase
Over-Capitalization
Over-capitalization and working capital
• If there are excessive inventories, accounts receivable and cash, and VERY
FEW accounts payable, there will be an over‐investment by the company in
current assets. Working capital will be excessive
• Indicators of over‐capitalization
Compare with previous years or similar companies

Sales/working capital Falling or a low sales/Working capital ratio
Liquidity ratios Compare with previous years or similar companies
Long turnover periods for inventory and accounts
receivable or
Improve Turnover periods Shorter credit period from suppliers may be
unnecessary
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Overtrading
• OVERTRADING happens when a business tries to do too much too
quickly (sale increases significantly) with too little long-term
capital (too much short-term capital, Ex: overdraft), so that it is
trying to support too large a volume of trade with short‐term
capital (mainly debt)
• Even if an overtrading business operates at a profit, it could easily
run into serious trouble because it is short of money (overdraft).
• Such liquidity troubles: not have enough capital to provide the
cash to pay its debts as they fall due.
Overtrading
• Symptoms of overtrading are as follows.
 There is a rapid increase in the volume of current assets and
possibly also non‐current assets.
 Inventory turnover and accounts receivable turnover might slow
down,
 The rate of increase in inventories and accounts receivable (>)
are even greater than the rate of increase in sales
 Most of the increase in assets is financed by credit, Trade
accounts payable, Bank overdraft
 Trade accounts payable ‐ the payment period to accounts
payable is longer
 A bank overdraft, which often reaches or even exceeds the limit
of the facilities agreed by the bank
 The current ratio and the quick ratio fall.
 Trade accounts payable, Bank overdraft
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Overtrading
• Solutions to Overtrading
 New capital could be injected from shareholders
 The growth can be financed through long‐term loans.
 Better control could be applied to management of
inventories and accounts receivable.
 The company could postpone ambitious plans for
increased sales and fixed asset investment.
NOTE: increase Long-term Finance (E & NCL), decrease Current
Asset
Over-Capitalization vs
Overtrading
PRACTICE 1:
Which of the following is not usually associated with overtrading?
A. An increase in the current ratio
B. A rapid increase in revenue
C. A rapid increase in the volume of current assets
D. Most of the increase in current assets being financed by credit
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Over-Capitalization vs
Overtrading
PRACTICE 2:
If Plot Co were overtrading, which TWO of the following could be
symptoms?
1 Decreasing levels of trade receivables
2 Increasing levels of inventory
3 Increasing levels of long term borrowings
4 Increasing levels of current liabilities
A. 1 and 3
B. 1 and 4
C. 2 and 3
D. 2 and 4
Q&A
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Part C
Chapter 5
Managing
Working Capital

Part 1. Managing Inventories
Part 2. Managing Account Receivable
Part 3. Managing Account Payable
Part 4. Managing Cash
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Managing Inventories
There are certain costs related to inventories:
INVENTORY COSTS
Holding costs • The cost of capital
• Warehousing and handling costs
• Deterioration
• Obsolescence
• Insurance
• Pilferage
Procuring costs • Ordering costs
• Delivery costs
Purchase cost of • Purchase price
inventory • Relevant particularly when calculating discounts for bulk
quantity purchases
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EXAMINATION QUESTIONS ABOUT ‘scientific’ control of inventories:
1. The economic order quantity (EOQ) model can be used to decide the
optimum order size for inventories
2. Discounts for bulk purchases, it may be cheaper to buy inventories in
large order sizes
3. Uncertainty in the demand for inventories and the supply lead time so
determine the buffer inventories, average inventory level
QUESTION TYPE 1: THE EOQ FORMULA
THREE ASSUMPTION:
1. Demand is constant, D = usage in units for one period (the demand)
2. The lead time is constant or zero
3. Purchase costs per unit P, Co, Ch are constant (ie no bulk discounts).
Co = Cost of placing one order
Ch = Holding cost per unit of inventory for one period
Q = Re‐order quantity
Q
Holding costs = Holding cost per unit × average inventory = Ch x
2
Cost of placing one order x Demand for one period C xD
Ordering costs = = 0
Re−order quantity Q
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QUESTION TYPE 1: THE EOQ FORMULA
The economic order quantity (EOQ) is the OPTIMAL ORDERING

QUANTITY for an item of inventory
2C0 D
EOQ =
Ch
EOQ is the quantity which can minimize this sum:
Holding costs + ordering costs
At EOQ: Holding costs = Ordering costs
Q C xD
Ch x = 0
2 Q
PRACTICE:
The following scenario relates to questions 1-2
Plot Co sells Product P with sales occurring evenly throughout the year.
Product P
The annual demand for Product P is 300,000 units and an order for new inventory
is placed each month.
Each order costs $267 to place. The cost of holding Product P in inventory is 10
cents per unit per year.
Buffer inventory equal to 40% of one month's sales is maintained.
Other information
Plot Co finances working capital with short‐term finance costing 5% per year.
Assume that there are 365 days in each year.
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QUESTION 1:
What is the total cost of the current ordering policy (to the nearest
whole number)?
A. $2,250
B. $2,517
C. $3,204
D. $5,454
QUESTION 2:
What is the total cost of an ordering policy using the economic order
quantity (EOQ) (to the nearest whole number)?
A. $3,001
B. $5,004
C. $28,302
D. $40,025
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PRACTICE:
LONG QUESTION: Sep, 2016, Nesud Co
Nesud Co purchases $2.4m per year of Component K at a price of $5 per
component. Consumption of Component K can be assumed to be at a constant
rate throughout the year. The company orders components at the start of each
month in order to meet demand and the cost of placing each order is $248.44. The
holding cost for Component K is $1.06 per unit per year.
Required
Evaluate whether Nesud Co should adopt an economic order quantity approach
to ordering Component K. (6 marks)
QUESTION TYPE 2: DISCOUNTS FOR BULK PURCHASES
Choose the MINIMUM quantity to earn BULK discount

Recalculation Ordering Cost & Holding Cost
Q
Holding costs = Holding cost per unit × average inventory = Ch x
2
Cost of placing one order x Demand for one period C xD

Ordering costs = = 0
Re−order quantity Q
Recalculation Purchase Cost

Purchase Cost = New discounted price x Demand
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QUESTION TYPE 2: DISCOUNTS FOR BULK PURCHASES
Different order quantity

CURRENT EOQ Minimum
quantity to
earn BULK
discount
Component Purchase cost x x X
costs of Ordering cost x x X
Holding cost x x X
Inventory
Total Cost
PRACTICE:
Cat Co places monthly orders with a supplier for 10,000 components which are
used in its manufacturing processes. Annual demand is 120,000 components. The
current terms are payment in full within 90 days, which Cat Co meets, and the cost
per component is $7.50. The cost of ordering is $200 per order, while the cost of
holding components in inventory is $1.00 per component per year.
The supplier has offered a discount of 3.6% on orders of 30,000 or more
components. If the bulk purchase discount is taken, the cost of holding
components in inventory would increase to $2.20 per component per year due to
the need for a larger storage facility.
Evaluate whether CAT CO should take the bulk discount (5 marks)
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QUESTION TYPE 3: IN CASE OF UNCERTAINTIES IN DEMAND AND LEAD TIMES
A re-order level systems
A re-order level systems

Uncertainties in demand and lead times taken to fulfil orders mean that
inventory will be ordered once it reaches a re‐order level:
Re-order level = Maximum usage x Maximum Lead time

The re‐order level is the measure of inventory at which a replenishment order
should be made.
 If an order is placed too late, the organisation may run out of inventory, a
stock‐out, resulting in a loss of sales and/or a loss of production.
 If an order is placed too soon, the organisation will hold too much
inventory, and inventory holding costs will be excessive.
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Maximum inventory level
= re-order level + re-order quantity – (minimum usage x minimum lead time)
The maximum level acts as a warning signal to management that inventories are
reaching a potentially wasteful level.
Buffer safety inventory (Minimum inventory level)
= re-order level – (average usage x average lead time)
 The buffer safety level acts as a warning to management that inventories are
approaching a dangerously low level and that stock‐outs are possible.
 Assumes: inventory levels fluctuate between the buffer safety inventory level
and the maximum inventory level (the amount of inventory immediately after an
order is received, safety inventory and re‐order quantity
re−order amount
Average inventory = buffer safety inventory +
2
‐> Calculate Holding cost
PRACTICE:
Question 1: EE Co has calculated the following in relation to its inventories.
• Buffer inventory level 50 units
• Reorder size 250 items
• Fixed order costs $50 per order
• Cost of holding onto one item pa $1.25 per year
• Annual demand 10,000 items
• Purchase price $2 per item
What are the total inventory related costs for a year (to the nearest whole $)?
…………………
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JUST IN TIME (JIT) PROCUREMENT
Just‐in‐time procurement is a term which describes a policy of obtaining

goods from suppliers at the latest possible time (ie when they are needed)
and so avoiding the need to carry any materials or components inventory
Introducing JIT might bring the following potential benefits.
o Reduction in inventory holding costs
o Reduced manufacturing lead times
o Improved labor productivity
o Reduced scrap/rework/warranty costs
JIT will not suitable in the case which a stock‐out is a serious damage (such
as a hospital)
JUST IN TIME (JIT) PROCUREMENT
IMPLICATIONS OF JUST IN TIME STOCK MANAGEMENT

 Supplier must be ideally located close to our organization
 There must be close working relationships with suppliers so that response to
the problems/developments can be immediate
 Only produce for customer demand hence no finished good stock
 DRAWBACK OF JIT: JIT will not suitable in the case which a stock‐out is a
serious damage (such as a hospital)
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PRACTICE:
Which of the following is NOT generally a benefit of a 'just in time' approach?
A. Lower inventory levels
B. Better product customisation
C. Ease of production scheduling
D. Higher quality
Managing account receivables
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Managing Accounts Receivable
• COST OF RECEIVABLE
o Administrative cost to record and collecting debts
o Cost of irrecoverable debts (Sales x % of bad debt)
o Cost of early Settlement Discount
= (Sales x % of discount x % of customers taken the discount)
o Finance Cost (Average Receivable x % of interest rate)
• PAST EXAM ON ACCOUNT RECEIVABLE MANAGEMENT – 3 TYPES
 Type 1: Early settlement discounts
 Type 2: Debt Factoring
 Type 3: Discussion about: Account Receivable management,

Foreign trade Receivable management
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QUESTION TYPE 1: EARLY SETTLEMENT DISCOUNT
Discounts for early settlement can be offered to customers.

• Benefits: Early settlement discounts may be employed
to shorten average credit periods, and to reduce the
investment in accounts receivable and therefore interest
costs.
• Cost: The cost of the discounts allowed.
• The annual effective rate of discount =
Where:
d = the discount offered (5% = 5, etc)
t = the reduction in the payment period in days
QUESTION TYPE 1: EARLY SETTLEMENT DISCOUNT
Current Policy Proposed Policy

Finance Cost of Receivable Finance Cost of Receivable
Bad debts Early Settlement Discount Cost
Administration cost Bad debts
Total Cost Total Cost
Compare them and choose with the least cost
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PRACTICE – EARLY SETTLEMENT DISCOUNT

XYZ Co has annual credit sales of $20m and accounts receivable of $4m.
Working capital is financed by an overdraft at 12% interest per year.
Assume 365 days in a year.
What is the annual financial effect if management reduces the collection
period to 60 days by offering an early settlement discount of 1% that all
customers adopt?
A. $85,479 benefit
B. $114,521 cost
C. $85,479 cost
D. $285,479 benefit
PRACTICE – EARLY SETTLEMENT DISCOUNT

WQZ CO (DEC 2010)
WQZ Co could introduce an early settlement discount of 1% for customers who pay within
30 days and at the same time, through improved operational procedures, maintain a
maximum average payment period of 60 days for credit customers who do not take the
discount. It is expected that 25% of credit customers will take the discount if it were offered.
It is expected that administration and operating cost savings of $753,000 per year will be
made after improving operational procedures and introducing the early settlement discount.
Credit sales of WQZ Co are currently $87·6 million per year and trade receivables are
currently $18 million. Credit sales are not expected to change as a result of the changes in
receivables management. The company has a cost of short‐term finance of 5·5% per year
Require:
c. Calculate and comment on whether the proposed changes in receivables management
will be acceptable. Assuming that only 25% of customers take the early settlement
discount, what is the maximum early settlement discount that could be offered? (6
marks)
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QUESTION TYPE 2: DEBT FACTORING
Factoring is an arrangement to have debts collected by a factor company,

which advances a proportion of the money it is due to collect.
The main aspects of factoring
• Administration of the client's invoicing, sales accounting and debt
collection service
• Making payments to the client in advance of collecting the debts. This is
sometimes referred to as 'factor finance' because the factor is providing cash
to the client against outstanding debts.
• Credit protection for the client's debts, whereby the factor takes over the
risk of loss from bad debts and so 'insures' the client against such losses. This
is known as a non-recourse service.
Factoring: RECOURSE & NON‐RECOURSE
Current Policy Proposed Policy (FACTORING)
 Finance Cost of Receivable (OLD AR)  Finance Cost of Receivable (NEW AR)
 Finance Cost of Advance  Finance Cost of Advance
 Factor Fee (sale)
 Bad debts (sale)  Bad debts with Factor
 Administration cost  Administration cost
Total Cost Total Cost
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Advantages Disadvantages
1. Business can pay its suppliers on time and 1. Factoring is likely to be more costly than
so be able to take early payment discounts. an internal credit control department.
2. Optimum inventory level can be 2. Customers may not like to deal with factors.
maintained because management will have 3. Factoring may have a bad reputation for
enough cash. the company. It may indicate that the
3. NOT INCUR The cost of running sales company has financial issues
ledger department
4. Business can use the expertise of debtor
management that the factor specializes.
5. Management time is saved because
managers don’t have to spend their time on
debtor management.
PRACTICE – DEBT FACTORING

L Co is considering whether to factor its sales invoices. A factor has offered
L Co a non recourse package at a cost of 1.5% of sales and an admin fee of
$6,000 per annum. Bad debts are currently 2% of sales per annum and
sales are $1.5m per annum.
What is the cost of the package of L Co?
$ ____________
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PRACTICE – DEBT FACTORING – WIDNOR CO JUNE 2015
The finance director of Widnor Co has been looking to improve the company's working capital
management. Widnor Co has revenue from credit sales of $26,750,000 per year and although
its terms of trade require all credit customers to settle outstanding invoices within 40 days, on
average customers have been taking longer.
Approximately 1% of credit sales turn into bad debts which are not recovered.
Trade receivables currently stand at $4,458,000
Widnor Co has a cost of short‐term finance of 5% per year.
The finance director is considering a proposal from a factoring company, Nokfe Co, which was
invited to tender to manage the sales ledger of Widnor Co on a with‐recourse basis.
Nokfe Co believes that it can use its expertise to reduce average trade receivables days to 35
days, while cutting bad debts by 70% and reducing administration costs by $50,000 per year.
A condition of the factoring agreement is that the company would also advance Widnor Co
80% of the value of invoices raised at an interest rate of 7% per year.
Nokfe Co would charge an annual fee of 0.75% of credit sales.
Assume that there are 360 days in each year.
Required
(a) Advise whether the factor's offer is financially acceptable to Widnor Co. (7 marks)
QUESTION TYPE 3: DISCUSSION ABOUT AR MANAGEMENT
KEY AREAS:
A. Formulation of policy
B. Assessment of creditworthiness
C. Managing accounts receivable
D. Collection of amounts due
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a. Formulation of policy
Several factors should be considered by management when a policy for credit
control is formulated:
• The administrative costs of debt collection.
• The procedures for controlling credit to individual customers and for debt
collection.
• The amount of extra capital required to finance an extension of total credit –
there might be an increase in accounts receivable, inventories and accounts
payable, and the net increase in working capital must be financed.
• The cost of the additional finance required for any increase in the volume of
accounts receivable (or the savings from a reduction in accounts receivable)
– this cost might be bank overdraft interest, or the cost of long‐term funds
(such as loan inventory or equity).

a. Formulation of policy
• Any savings or additional expenses in operating the credit policy (for

example the extra work involved in pursuing slow payers).
• The ways in which the credit policy could be implemented – for example:
o Credit could be eased by giving accounts receivable a longer period in
which to settle their accounts – the cost would be the resulting
increase in accounts receivable.
• A discount could be offered for early payment – the cost would be the
amount of the discounts taken.
• The effects of easing credit, which might be to encourage a higher
proportion of bad debts, and an increase in sales volume. Provided that
the extra gross contribution from the increase in sales exceeds the
increase in fixed cost expenses, bad debts, discounts and the finance cost
of an increase in working capital, a policy to relax credit terms would be
profitable.
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b. Briefly discuss how the creditworthiness of potential customers can be assessed
• References are useful in this respect, and potential customers should

supply a bank reference and a trade or other reference when seeking
credit on purchases.
• Another source of information is the credit rating of the potential
customer, which can be checked by a credit rating agency or credit
reference agency.
• For larger potential customers, a file can be opened where additional
information can be located, evaluated and stored, such as the annual
report and accounts of the potential customer, press releases and so on

b. Asssessment of creditworthiness
• The creditworthiness of customers needs to be assessed. The risks and

costs of a customer defaulting will need to be balanced against the
profitability of the business provided by that customer.
• Information relating to a new customer needs to be analyzed. The greater
the amount of credit being granted and the possibility of repeat business,
the more credit analysis is needed.
32

c. Managing accounts receivable
Regular monitoring of accounts receivable is very important. The overall level of

accounts receivable can be monitored using an aged accounts receivable listing and
credit utilization report, as well as reports on the level of bad debts.
• Accounts receivable' payment records must be monitored continually
• Credit monitoring can be simplified by a system of in‐house credit ratings
• A customer's payment record and the accounts receivable aged analysis
should be examined regularly, as a matter of course. Breaches of the credit
limit, or attempted breaches of it, should be brought immediately to the
attention of the credit controller

d. Collection of amounts due
The overall debt collection policy of the firm should be such that the administrative
costs and other costs incurred in debt collection do not exceed the benefits from
incurring those costs.
Collecting debts is a two‐stage process.
• Having agreed credit terms with a customer, a business should issue an
invoice and expect to receive payment when it is due
• If payments become overdue, they should be 'chased'. Procedures for
pursuing overdue debts must be established such as instituting reminders,
chasing payment by telephone, making a personal approach, notifying
debt collection section, handing over debt collection to specialist debt
collection section, take legal action.
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PRACTICE – DISCUSSION
WQZ CO (DEC, 2010)
Discuss the factors that should be considered in formulating working
capital policy on the management of trade receivables (8 marks)

QUESTION TYPE 3: DISCUSSION ABOUT MANAGING FOREIGN ACCOUNTS AR
MANAGING FOREIGN ACCOUNTS RECEIVABLE
Foreign debts raise the following special problems.

• There are delays in foreign trade which make exporters often build up large
investments in inventories and accounts receivable:
 When goods are sold abroad, the customer might ask for credit. Exports
take time to arrange, and there might be complex paperwork.
 Transporting the goods can be slow, if they are sent by sea.
• The risk of bad debts can be greater with foreign trade than with domestic
trade. If a foreign debtor refuses to pay a debt, the exporter must pursue the
debt in the debtor's own country, where procedures will be subject to the
laws of that country.
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MANAGING FOREIGN ACCOUNTS RECEIVABLE
Measures to help exporters overcome these problems

• Reducing the bad debt risk: An exporting company should vet the
creditworthiness of each customer, and grant credit terms accordingly
• Export factoring
• Documentary credits (LC)
• Countertrade: financing trade in which goods are exchanged for other goods
• Export credit insurance: insurance against the risk of non‐payment by foreign
customers for export debts.
• REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE

• Letter of Credit
This is a way of reducing the investment in foreign accounts receivable and a
risk-free method of securing payment for goods or services
• Counter Trading
In a countertrade arrangement, goods or services are exchanged for other goods or
services instead of for cash.
The benefits : it facilitates conservation of foreign currency risk, eliminate the foreign
account receivable
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• Export Credit Insurance

Export credit insurance protects a business against the risk of non‐payment by a
foreign customer.
• Export credit insurance insures insolvency of the purchaser or slow payment,
insures against certain political risks, for example war, riots.
Disadvantages: high cost of premiums fee
• Export Factoring
An export factor provides the same functions in relation to foreign accounts
receivable as a factor covering domestic accounts receivable and therefore can
help with the cash flow of a business.
Disadvantage: export factoring can be more costly than export credit insurance
and it may not be available for all countries, particularly developing countries
Managing Account Payables

PAYABLES MANAGEMENT
Delaying payment to suppliers to Delaying too much may cause

obtain free source of finance difficulties for the company
Trade payable is a cheap and most important source of short‐term finance as it

carries no interest.
Management of trade payables involve
 Attempting to obtain satisfactory credit terms from suppliers
 Attempting to extend credit during periods of cash shortage
 Maintaining good relationships with regular and important suppliers
36
• The cost of lost early payment discounts (same formula used for
account receivable) 365
100 t
• The annual effective rate of discount = 1− %
100 − d
• Where:
• d = the discount offered (5% = 5, etc)
• t = the reduction in the payment period in days
PRACTICE – NESUD CO, SEP 2016

• Nesud Co has credit sales of $45m per year and on average settles accounts
with trade payables after 60 days. One of its suppliers has offered the
Company an early settlement discount of 0.5% for payment within 30 days.
Administration costs will be increased by $500 per year if the early
settlement discount is taken. Nesud Co buys components worth $1.5m per
year from this supplier.
• The finance director of Nesud Co is concerned that approximately 1% of
credit sales turn into irrecoverable debts. In addition, she has been advised
that customers of the company take an average of 65 days to settle their
accounts, even though Nesud Co requires settlement within 40 days. Nesud
Co finances working capital from an overdraft costing 4% per year. Assume
there are 360 days in a year.
• Required
• (a) Evaluate whether Nesud Co should accept the early settlement discount
offered by its supplier. (4 marks)
37
Managing Cash
Cash Management Models
4 TYPES OF QUESTIONS
1. Cash flow forecast
2. The miller-orr model: the upper and lower limits and the
return point (CASH LEVEL) are set based on variance of cash
flows, transaction costs and interest rates
3. The baumol model: optimum cash balances is like deciding on
optimum inventory levels optimum CASH levels
4. Treasury management: CASH SURPLUS/ DEFICIT
Managing Cash
There is 3 reasons for holding cash

• Transaction motive: a business needs cash to meet its regular
commitments
• Precautionary motive: This means that there is a need to maintain a
'buffer of cash for unforeseen contingencies
• Speculative motive. Some businesses hold surplus cash as a
speculative asset in the hope that interest rates will rise holding cash
has a cost – the loss of earnings which would otherwise have been
obtained by using the funds in another way. The financial manager
must try to balance liquidity with profitability
38
Managing Cash
QUESTION TYPE 1: CASH FLOW FORECAST
Cash flow problems

Cash flow problems can arise in various ways.
• Making losses
• Inflation
• Growth
• Seasonal business
• One‐off items of expenditure
Managing Cash
• A cash flow forecast

is a detailed forecast
of cash inflows and
outflows
incorporating both
revenue and capital
items.
• A cash flow forecast
might be drawn up
in the following
format
39
Managing Cash
Managing Cash
Notice on what to include in a cash flow forecast

• Not all cash receipts affect income statement income.
• Not all cash payments affect income statement expenditure.
• profit or loss on sale of non‐current assets or depreciation are
not cash items.
• The timing of cash receipts and payments may not coincide
with the recording of income statement transactions.
40
Managing Cash
PRACTICE – TYPE 1
• JP Co has budgeted that sales will be $300,100 in January 20X2, $501,500 in
February, $150,000 in March and $320,500 in April. Half of sales will be credit
sales. 80% of receivables are expected to pay in the month after sale, 15% in
the second month after sale, while the remaining 5% are expected to be bad
debts.
• Receivables who pay in the month after sale can claim a 4% early settlement
discount.
• What level of sales receipts should be shown in the cash budget for March
20X2 (to the nearest $)?
• $ _____________
Managing Cash
QUESTION TYPE 2: THE BAUMOL MODEL
• The Baumol model is based on the idea that deciding on optimum cash balances is like
deciding on optimum inventory levels.
• It assumes that cash is steadily consumed over time and a business holds a stock of
marketable securities that can be sold when cash is needed.
• The cost of holding cash is the opportunity cost ie the interest foregone from not
investing the cash.
• The cost of placing an order is the administration cost incurred when selling the
securities
• Similarly to the EOQ, costs are minimised when:
2CS
Q=
i
Where
• S = the amount of cash to be used in each time period
• C = the cost per sale of securities
• i = the interest cost of holding cash or near cash equivalents
• Q = the total amount to be raised to provide for S
41
Managing Cash
QUESTION TYPE 2: THE BAUMOL MODEL
Drawbacks:
• In reality, it is unlikely to be possible to predict amounts required over future
periods with much certainty.
• No buffer inventory of cash is allowed for. There may be costs associated with
running out of cash
• There may be other normal costs of holding cash which increase with the
average amount held.
Managing Cash
PRACTICE – TYPE 2
• WW Co is a subsidiary of BB Co. WW Co requires $10m in finance to be
easily spread over the coming year, which BB Ltd will supply. Research
shows:
• There is a standing bank fee of $200 for each drawdown.
• The net interest cost of holding cash (ie finance cost less deposit interest) is
6% pa.
• According to the Baumol model, what is the optimum amount WW Co
should draw down at a time (to the nearest $'000)?
• $ ________________
42
Managing Cash
QUESTION TYPE 3: THE MILLER-ORR MODEL
• Miller‐Orr model can be understood by asking what will happen if there is no
attempt to manage cash balances. Clearly, the cash balance is likely to
'meander' upwards or downwards. The Miller‐Orr model imposes limits to
this meandering.
 If the cash balance reaches an upper limit (point A) the firm buys
sufficient securities to return the cash balance to a normal level (called
the 'return point').
 When the cash balance reaches a lower limit (point B), the firm sells
securities to bring the balance back to the return point.
Managing Cash
43
Managing Cash
The upper and lower limits and the return point are set based on variance of
cash flows, transaction costs and interest rates.
• If the day‐to‐day variability of cash flows is high or the transaction cost in
buying or selling securities is high, then wider limits should be set.
• If interest rates are high, the limits should be closer together.
1
Return point = Lower limit + x spread
3
The formula for the spread is:
1
3 Transaction cost x Variance of cash flows 3
Spread = 3 x
4 Interest rate
Managing Cash
To use the Miller‐Orr model, it is necessary to follow the steps below.
• Set the lower limit for the cash balance. This may be zero, or it may be set at
some minimum safety margin above zero.
• Estimate the variance of cash flows, for example from sample observations
over a 100‐day period.
• Note the interest rate and the transaction cost for each sale or purchase of
securities (the latter is assumed to be fixed).
• Compute the upper limit and the return point from the model and
implement the limits strategy.
44
Managing Cash
PRACTICE – TYPE 3
The treasury department in TB Co has calculated, using the Miller-Orr model, that the lowest cash
balance they should have is $1m, and the highest is $10m. If the cash balance goes above $10m
they transfer the cash into money market securities.
Are the following true or false?
True False
1. When the balance reaches $10m they would buy $6m of securities
2. When the cash balance falls to $1m they will sell $3m of securities
3. If the variance of daily cash flows increases the spread between upper
and lower limit will be increased.
Managing Cash
PRACTICE – PAST EXAM

Flit Co is preparing a cash flow forecast for the three‐month period from January to the
end of March. The following sales volumes have been forecast
December January February March April
Sales (units) 1,200 1,250 1,300 1,400 1,500

Notes:
1 The selling price per unit is $800 and a selling price increase of 5% will occur in February.
Sales are all on one month's credit.
2 Production of goods for sale takes place one month before sales.
3 Each unit produced requires two units of raw materials, costing $200 per unit. No raw
materials inventory is held. Raw material purchases are on one months' credit.
4 Variable overheads and wages equal to $100 per unit are incurred during production,
and paid in the month of production.
5 The opening cash balance at 1 January is expected to be $40,000.
6 A long‐term loan of $300,000 will be received at the beginning of March.
A machine costing $400,000 will be purchased for cash in March
45
Managing Cash
PRACTICE – PAST EXAM

Required.
(a) Calculate the cash balance at the end of each month in the three-month
period. (5 marks)
(d) Explain how the Baumol model can be employed to reduce the costs of
cash management. (5 marks)
(e) Renpec Co, a subsidiary of Flit Co, has set a minimum cash account balance
of $7,500. The average cost to the company of making deposits or selling
investments is $18 per transaction and the standard deviation of its cash
flows was $1,000 per day during the last year. The average interest rate on
investments is 5.11%.
Determine the spread, the upper limit and the return point for the cash
account of Renpec Co using the Miller-Orr model and explain the relevance
of these values for the cash management of the company. (5 marks)
Managing Cash
QUESTION TYPE 4: TREASURY MANAGEMENT
Cash position Appropriate management action
Short‐term • Pay accounts payable early to obtain discount
surplus • Attempt to increase sales by increasing accounts receivable and
inventories
• Make short‐term investments
Short‐term deficit • Increase accounts payable by delaying payments to suppliers
• Reduce accounts receivable by improving collection of overdue payments
• Arrange a bank overdraft facility, or increase the limit on an existing
facility
Long‐term surplus • Make long‐term investments

• Expand
• Diversify
• Replace/update non‐current assets
• Distribute the surplus to shareholders
Long‐term deficit • Raise long‐term finance (such as via issue of share capital)
• Consider shutdown/disinvestment opportunities
46
Managing Cash
Methods of easing cash shortages

The steps that are usually taken by a company when a need for cash arises, and when it
cannot obtain resources from any other source such as a loan or an increased overdraft,
are as follows.
• Postponing capital expenditure
• Some new non‐current assets might be needed for the development and growth of
the business, but some capital expenditures might be postponable without serious
consequences
• Accelerating cash inflows which would otherwise be expected in a later period
• It might be possible to encourage accounts receivable to pay more quickly by
offering discounts for earlier payment.
• Reversing past investment decisions by selling assets previously acquired
• Some assets are less crucial to a business than others. If cash flow problems are
severe, the option of selling investments or property might have to be considered.
Managing Cash
Methods of easing cash shortages

Negotiating a reduction in cash outflows, to postpone or reduce payments
• Longer credit might be taken from suppliers. Such an extension of credit
would have to be negotiated carefully: there would be a risk of having
further supplies refused.
• Loan repayments could be rescheduled by agreement with a bank.
• A deferral of the payment of company tax might be agreed with the
taxation authorities. They will however charge interest on the outstanding
amount of tax.
• Dividend payments could be reduced. Dividend payments are
discretionary cash outflows, although a company's directors might be
constrained by shareholders' expectations, so that they feel obliged to pay
dividends even when there is a cash shortage.
47
Managing Cash
• Treasury management can be defined as: 'The corporate handing of all financial
matters, the generation of external and internal funds for business, the
management of currencies and cash flows, and the complex strategies, policies
and procedures of corporate finance.' (Association of Corporate Treasurers)
• Large companies rely heavily on the financial and currency markets. These
markets are volatile, with interest rates and foreign exchange rates changing
continually and by significant amounts. To manage cash (funds) and currency
efficiently, many large companies have set up a separate treasury department.
• Treasury management can follow centralization or decentralization
Managing Cash
Benefits of centralization Benefits of decentralization

• Centralised liquidity management • Sources of finance can be diversified and
• Any borrowing can be arranged in bulk, can match local assets
at lower interest rates than for smaller • Greater autonomy can be given to
borrowings subsidiaries and divisions because of the
• Foreign exchange risk management is closer relationships they will have with
likely to be improved in a group of the decentralised cash management
companies function
• A specialist treasury department can • more responsive to the needs of
employ experts individual operating units
• The centralised pool of funds required
for precautionary purposes will be
smaller than the sum of separate
precautionary balances
48
Q&A
Part C
Chapter 6
Working Capital
Finance
49
Part 1. Working capital investment policy
Part 2. Working capital financing policy
Working capital investment policy
Working Capital Investment Policy: A company can adopt a

working capital strategy for managing its working capital
depending on the important risks associated with working capitals.
Three different working capital Investment policies:

• Conservative Approach
• Aggressive Approach
• Moderate Approach
50
A CONSERVATIVE APPROACH: reduce the risk of system breakdown by
holding high levels of working capital.
• Customers are allowed generous payment terms to stimulate demand,
• Finished goods inventories are high to ensure availability for customers,
• Raw materials and work in progress are high to minimise the risk of
running out of inventory and consequent downtime in the
manufacturing process.
• Suppliers are paid promptly to ensure their goodwill, again to minimise
the chance of stock‐outs.
• However, the drawback are:
• That the firm carries a high burden of unproductive assets, resulting in a
financing cost that can destroy profitability.
• A period of rapid expansion may also cause severe cash flow problems as
working capital requirements outstrip available finance.
• Further problems may arise from inventory obsolescence.

AN AGGRESSIVE APPROACH
• An aggressive working capital management policy aims to
reduce this financing cost and increase profitability by:
 cutting inventories,
 speeding up collections from customers,
 and delaying payments to suppliers.
• The 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.
51
A MODERATE APPROACH
• A moderate working capital management policy is a middle way
between the aggressive and conservative approaches.
• These characteristics are useful for comparing and analysing the
different ways individual organisations deal with working capital
and the trade off between risk and return
Working capital financing policy
Working Capital Financing Policy: how a company finance its

working capital by short‐term finance and long‐term finance
Three different working capital Financing policies:

• Conservative Approach
• Aggressive Approach
• Moderate Approach
52
• The dotted lines A, B and C are

the cut‐off levels between short-
term and long-term funding:
• Assets above the relevant dotted
line are financed by short-term
funding while assets below the
dotted line are financed by long-
term funding
• A: Conservative approach
• B: Aggresssive approach
• C: Moderate approach
PERMANENT AND FLUCTUATING CURRENT ASSETS

In order to understand working capital financing decisions, assets can
be divided into three different types.
• Non‐current (fixed) assets are long‐term assets from which an
organisation expects to derive benefit over a number of periods. For
example, buildings or machinery.
• Permanent current assets are the amount required to meet long‐term
minimum needs and sustain normal trading activity. For example,
inventory and the average level of accounts receivable.
• Fluctuating current assets are the current assets which vary according
to normal business activity. For example due to seasonal variations.
Fluctuating current assets together with permanent current assets may
be financed by either long‐term funding (including equity capital) or by
current liabilities (short‐term funding).
53
POLICY A:
Can be characterised as a conservative approach to financing

working capital.
• All non‐current assets and permanent current assets, as well as
part of the fluctuating current assets, are financed by long-
term funding.
• There is only a need to call upon short‐term financing at times
when fluctuations in current assets push total assets above the
level of dotted line A.
• At times when fluctuating current assets are low and total
assets fall below line A, there will be surplus cash which the
company will be able to invest in marketable securities.
POLICY B:
Policy B is a more aggressive approach to financing working capital.

• Not only are fluctuating current assets all financed out of short‐
term sources, but so are some of the permanent current assets.
• This policy represents an increased risk of liquidity and cash flow
problems, although potential returns will be increased if short‐term
financing can be obtained more cheaply than long‐term finance.
54
POLICY C:
A balance between risk and return might be best achieved by the

moderate approach of policy C.
• A policy of maturity matching in which long‐term funds finance
permanent assets while short‐term funds finance non‐
permanent assets.
• This means that the maturity of the funds matches the maturity
of the assets.
PRACTICE 1:
Which statement best reflects an aggressive working capital
finance policy?
A. More short‐term finance is used because it is cheaper
although it is risky.
B. Investors are forced to accept lower rates of return.
C. More long‐term finance is used as it is less risky.
D. Inventory levels are reduced.
55
PRACTICE 2:
What are the TWO key risks for the borrower associated with
short-term working capital finance?
A. Rate risk
B. Renewal risk
C. Inflexibility
D. Maturity mismatch
Q&A
56

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ACCA – APPLIED SKILLS

Part 2. Objectives of Working Capital management

Part 3. The Cash Operating Cycle

Part 4. Working Capital ratios

Part 5. Over-Capitalization vs Overtrading

The nature of Working Capital

 There is always a CONFLICT between liquidity and profitability.

Working capital ratio

Conservative Aggressive Miler – Orr

WC Finace Invoice Investing

The Cash operating cycle

• Improving production efficiency

Working Capital Ratios

Current Assets − Inventories

Working Capital Ratios

Average trade payables

• The accounts payable payment period often helps to assess a

Working Capital Ratios

Average raw materials inventory

Working Capital Ratios

Generally closing balances will be considered as average balances.

In the absence of purchases, Cost of sales will be used.

If not given, all inventory will be considered as finished goods

Working Capital Ratios

Compare with previous years or similar companies

Chapter 5 – Main parts

Part 2. Managing Account Receivable

Part 3. Managing Account Payable

Part 4. Managing Cash

The economic order quantity (EOQ) is the OPTIMAL ORDERING

Buffer inventory equal to 40% of one month's sales is maintained.

Choose the MINIMUM quantity to earn BULK discount

Cost of placing one order x Demand for one period C xD

Recalculation Purchase Cost

Different order quantity

Evaluate whether CAT CO should take the bulk discount (5 marks)

A re-order level systems

A re-order level systems

Re-order level = Maximum usage x Maximum Lead time

Just‐in‐time procurement is a term which describes a policy of obtaining

IMPLICATIONS OF JUST IN TIME STOCK MANAGEMENT

Managing account receivables

Managing Accounts Receivable

• PAST EXAM ON ACCOUNT RECEIVABLE MANAGEMENT – 3 TYPES

 Type 1: Early settlement discounts

 Type 2: Debt Factoring

 Type 3: Discussion about: Account Receivable management,

QUESTION TYPE 1: EARLY SETTLEMENT DISCOUNT

Discounts for early settlement can be offered to customers.

Managing Accounts Receivable

QUESTION TYPE 1: EARLY SETTLEMENT DISCOUNT

Current Policy Proposed Policy

Compare them and choose with the least cost

PRACTICE – EARLY SETTLEMENT DISCOUNT

Managing Accounts Receivable

PRACTICE – EARLY SETTLEMENT DISCOUNT

QUESTION TYPE 2: DEBT FACTORING

Factoring is an arrangement to have debts collected by a factor company,