CHAPTER FOUR

MANAGING CURRENT ASSETS

 INTRODUCTION

• Managing current assets or working capital

management is one of the important parts of
the financial management.

• It is concerned with short-term finance of the

business concern which is a closely related
trade between profitability and liquidity.

• Efficient working capital management leads to

improve the operating performance of the
business concern and it helps to meet the
short term liquidity.
 Cont…

• Hence, study of working capital

management is not only an important
part of financial management but also is
overall management of the business
concern.

• Working capital is described as the

capital which is not fixed but the more
common uses of the working capital is
to consider it as the difference between
the book value of current assets and
current liabilities.
 Working capital terminologies
• Capital of the business concern may be divided into two major
headings.

• Fixed capital means that capital, which is used for long-term

investment of the business concern. For example, purchase of
permanent assets. Normally it consists of non-recurring in nature.

• Working Capital is another part of the capital which is needed for

meeting day to day requirement of the business concern. For
example, payment to creditors, salary paid to workers, purchase of
raw materials etc., normally it consists of recurring in nature. It
can be easily converted into cash. Hence, it is also known as short-
term capital.
 TYPES (CLASSIFICATION) OF WORKING CAPITAL

• Working capital can be classified on the basis of

concept and periodicity.
A. On the basis of concept:

• Gross working capital: is the capital invested in total

current assets of the business concern. Gross Working
Capital is simply called as the total current assets of
the concern.
• Net working capital: is the specific concept, which
considers both current assets and current liability of the
concern.

• Net Working Capital is the excess of current assets over

the current liability of the concern during a particular
period.

• If the current assets exceed the current liabilities it is

said to be positive working capital; in the reverse, it is
said to be Negative working capital.

B. On the basis of periodicity(time):

• Working Capital may be classified into three important types
on the basis of time.
Working capital on the basis of time
1. Permanent Working Capital
• It is also known as Fixed Working Capital. It is the
capital; the business concern must maintain certain
amount of capital at minimum level at all times.

• The level of Permanent Capital depends upon the

nature of the business. Permanent or Fixed Working
Capital will not change irrespective of time or
volume of sales.

• The need for working capital fluctuates from time to

time. However, to carry on day-to-day operations of
the business without any obstacles, a certain
minimum level of raw materials , work in process,
finished goods and cash must be maintained on a
continues basis.
• The amount needed to maintain current assets on this
minimum level is called permanent or regular working
capital. The amount involved as permanent working
capital has to be met from long-term sources of finance,
e.g., capital, debentures and long-term loans.
2. Temporary Working Capital
• Any amount over and above the permanent working
capital is called temporary, fluctuating or variable
working capital.

• Due to seasonal changes, level of business activities is

higher than normal during some months of year and
therefore additional working capital will be required along
with the permanent working capital.
• It is so because during peak season, demand rises and
more stock is to be maintained to meet the demand.
Both types of working capital are necessary to run the
business.
• Temporary working capital is the amount of capital
which is required to meet the Seasonal demands and
some special purposes.

• It can be further classified into Seasonal Working

Capital and Special Working Capital.

• The capital required to meet the seasonal needs of

the business concern is called as Seasonal Working
Capital.

• The capital required to meet the special exigencies

such as launching of extensive marketing campaigns
for conducting research is called as special working
capital.
Permanent and Temporary working capital

•The Permanent is constant and temporary is

fluctuating according to seasonal demand.
3. Semi Variable Working Capital
• Certain amount of Working Capital is in the field level
up to a certain stage and after that it will increase
depending upon the change of sales or time.
 NEEDS OF WORKING CAPITAL

Working Capital is needed for the following purposes:

• Purchase of raw materials and spares: The basic
part of manufacturing process is raw materials.
 It should purchase frequently according to the
needs of the business concern.
 Hence, every business concern maintains certain
amount as Working Capital to purchase raw
materials, components, spares, etc.
• Payment of wages and salary: The next part of
Working Capital is payment of wages and salaries to
labor and employees.
– Periodical payment facilities make employees
perfect in their work.
– So a business concern maintains adequate amount
of working capital to make the payment of wages
and salaries.
• Day-to-day expenses: A business concern
has to meet various expenditures regarding
the operations at daily basis like fuel, power,
office expenses, etc.

• Provide credit obligations: A business

concern responsible to provide credit facilities
to the customer and meet the short-term
obligation. So the concern must provide
adequate Working Capital.
 WORKING CAPITAL POSITION/ BALANCED
WORKING CAPITAL POSITION
• A business concern must maintain a sound working
capital position to improve the efficiency of business
operation and efficient management of finance.
• Both excessive and inadequate Working Capital
positions are dangerous from firm’s point of view.

– Excessive working capital means holding costs and

idle funds which earn no profit for the firm.
– Paucity (inadequate) of working capital not only
impairs profitability but also results in production
interruptions and inefficiencies and sales
disruption.
Advantages of Adequate working capital:
• Availability of raw materials regularly
• Full utilization of fixed assets
• Cash discount
• Increase in credit rating
• Advantage of favorable business opportunities
• Facility in obtaining bank loans
• Increase in efficiency of management
• Meeting unseen contingencies
Disadvantages of Excessive working
management:
• Excessive inventory
• Excessive debtors
• Adverse effect on profitability
• Inefficiency of management
Disadvantages of Inadequate working
management:
• Difficulty in availability of raw materials
• Full utilization of fixed assets not possible
• Difficulty in maintenance of machinery
• Decrease in credit rating
• Non utilization of favorable opportunities
• Decrease in sales
• Difficulty in the distribution of dividends
• Decrease in the efficiency of management
FACTORS DETERMINING WORKING CAPITAL
REQUIREMENTS:
• Working Capital requirements depends upon various
factors.
• There are no set of rules or formula to determine the
Working Capital needs of the business concern.
• The following are the major factors which are determining
the Working Capital requirements.
 Nature of business - Availability of credit
from
banks
 Production cycle - Volume of profit
 Business cycle - Level of taxes
 Production policy - Dividend policy
 Credit policy - Depreciation policy
 Growth and expansion - Price level changes
 Availability of raw materials - Efficiency of
management
 Earning capacity
Nature of Business
• Working capital requirements of a firm are basically
influenced by the nature of its business.
I. Public utilities have a very limited need for working
capital and have to invest abundantly in fixed assets.
This is because they may have only cash sales and
supply services, not products.
 Thus, no funds will be tied up in debtors and stock
(inventories)
II. Trading and financial firms have a very small
investment in fixed assets, but require a large sum of
money to be invested in working capital. WC is high
because they have to stock a variety of goods.

III. Manufacturing -WC requirement fall between the

two extreme requirements of trading firms and public
utilities.
Production (manufacturing) cycle
• The manufacturing cycle (or the inventory conversion
cycle) comprises of the purchase and use of raw
materials and the production of finished goods.
• It covers the time span from procurement till the time
it becomes finished goods.
• Longer the manufacturing cycles, larger will be the
firm’s working capital requirements.
• E.g. Sugar Factory Vs Beer Factory
Production policy
• A strategy of constant production may be
maintained in order to resolve the working capital
problems arising due to seasonal changes in the
demand for the firm’s product.

• A steady production policy will cause inventories

to accumulate during the off-season periods and
the firm will be exposed to greater inventory
costs and risks.

• Thus, if costs and risks of maintaining a constant

production schedule are high, the firm may adopt
a variable production policy, varying its
production schedules in accordance with
changing demand.
Credit Policy
• The credit policy of a firm in its dealings with debtors
and creditors influences considerably the requirements
of working capital investment.
• A firm that purchases on credit and sells its
products/services on cash requires lesser amount of
working capital investment.
• On the other hand, a firm buying its requirements for
cash and allowing credit to its customers shall need
larger amount of working capital investment as very
huge amount of funds are bound to be tied up in
accounts receivable.
Business cycle
• During the period of boom, production is more and WC
is high.
• During a period of recession, production decline, the
requirement of WC is low.
Growth and expansion
 More fixed assets and more working capital
 Product diversification
 Expanding existing product line
 New business line.
Availability of Credit from suppliers
• The working capital requirements of a firm are also
affected by credit terms granted by it suppliers.

• A firm will needless working capital if liberal credit

terms are available to it from suppliers.

• In the absence of suppliers credit, the firm either

has to hold cash or borrow from bank (which is
interest bearing).
Profit level
 The net profit is the source of working capital to the
extent that it has been earned in cash.
 Higher profit margins would improve the prospects of
generating more internal funds there by contributing
to the working capital needs.
Level of taxes
 The first appropriation of profit is tax.
 Taxes may be payable in advance depending on
previous profit.
 If tax liability is increased, working capital
requirement will be high.
Price level changes
 During period of inflation to maintain the same level
of requirement additional investment is needed.

 The situation has an effect only at initial position

because the company also sells the product at high
amount. In this case WC increase drastically
Operating Efficiency
 The operating efficiency of the firm related to the
optimum utilization of resources at minimum costs.

 The firm will be effectively contributing in keeping the

working capital investment at a lower level if it is
efficient in controlling operation costs and utilizing
current assets.
APPROACHES (METHODS) OF ESTIMATING WORKING CAPITAL REQUIREMENTS

• Working Capital requirement depends upon the

number of factors.
• A number of methods are used to determine working
capital needs of a business. The important among
them are:

A. Percent of sales method

• Based on the past experience between Sales and
Working Capital requirements, a ratio can be
determined for estimating the Working Capital
requirement in future.

• It is the simple and tradition method to estimate the

Working Capital requirements.
• Under this method, first we have to find out the sales
to Working Capital ratio and based on that we have to
estimate Working Capital requirements.
• This method also expresses the relationship between
the Sales and Working Capital.
B. Operating Cycle Method
• Working Capital requirements depend upon the
operating cycle of the business.
• The operating cycle begins with the acquisition of raw
materials and ends with the collection of receivables.

• Operating cycle is the time span the firm requires in

the purchase of raw materials, conversion of raw
materials in to work in process and finished goods,
conversion of finished goods in to sales and in
collecting cash from debtors.
• Longer the time span of operating cycle, larger the
investment in current assets.
• Hence, time period of each stage of operating
cycle is estimated and then working capital
needed in each stage is computed on the basis of
cost of each item.

• Following factors should be taken in to

consideration while forecasting working capital
requirement on the basis of operating cycle
method:

• Cost of raw materials, wages and overheads

• Period during which raw material remains in
store before it is issued for production purpose
• Period of production cycle
• Period during which finished goods is stored
before sale
• Period of credit allowed to debtors and period of
credit allowed by suppliers
• Time lag in payment of wages and overheads
• Minimum cash balance required to be maintained

Note: A certain percentage for contingencies may

be added to the above estimates to determine
the working capital requirement.
Generally, operating cycle consists of the following
stages:
1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)
• Each component of the operating cycle can be
calculated by the following formula:
R= Average Stock of Raw Material
Average Raw Material Consumption per Day

W= Average Work in Process Inventory

Average Cost of Production per Day

F= Average Finished Stock Inventory

Average Cost of Goods Sold Per Day

D= Average Book Debts

Average Credit Sales per Day

C= Average Trade Creditors

Average Credit Purchase per Day
Example
From the following information extracted from the
books of a manufacturing company, compute the
operating cycle in days :
• Period Covered 365 days
• Average period of credit allowed by suppliers 16 days
• Average Total of Debtors Outstanding Br 48000
• Raw Material Consumption 440,000
• Total Production Cost 1,000,000
• Total Cost of Sales 1,050,000
• Sales for the year 1,600,000
• Value of Average Stock maintained:
• Raw Material 32,000
• Work-in-progress 35,000
• Finished Goods 26,000
 R= Average Stock of Raw Material
Average Raw Material Consumption per Day
= 32000 = 26.6 days
1205.5
W= Average Work in Process Inventory = 35000 =12.8
days
Average Cost of Production per Day 2739.73
F= Average Finished Stock Inventory = 26000 =9.0
days
Average Cost of Goods Sold Per Day 2876.7
D= Average Book Debts = 48000 = 10.95
days
Average Credit Sales per Day 4383.56
Operating Cycle In Days = R+W+F+D-C
= 26.6+12.8+9+11- 16 = 34.4 days
 WORKING CAPITAL MANAGEMENT POLICY

• Working Capital Management formulates policies to

manage and handle efficiently; for that purpose, the
management established three policies based on the
relationship between Sales and Working Capital.
1. Conservative Working Capital Policy.
2. Moderate Working Capital Policy.
3. Aggressive Working Capital Policy.
1. Conservative (restricted) working capital policy:
 refers to minimize risk by maintaining a higher level of
Working Capital. This type of Working Capital Policy is
suitable to meet the seasonal fluctuation of the
manufacturing operation. A policy under which
relatively large amounts of cash, marketable securities,
and inventories are carried and under which sales are
stimulated by a liberal credit policy, resulting in a high
level of receivables.
2. Moderate working capital policy: refers to the
moderate level of Working Capital maintenance according
to moderate level of sales. Or a policy that is between the
relaxed and restricted policies.
3. Aggressive (relaxed) working capital policy:
Aggressive Working Capital Policy is one of the high risky
and profitability policies which maintain low level of
Working Capital against the high level of sales, in the
business concern during a particular period. Or a policy
under which holdings of cash, securities, inventories, and
receivables are minimized.
 Determining the Finance Mix

• Determining the finance mix is an important part of

working capital management. Under this decision,
the relationship among risk, return and liquidity
are measured and also which type of financing is
suitable to meet the Working Capital requirements of
the business concern.
• There are three basic approaches for determining an
appropriate Working Capital finance mix.
1. Hedging or matching approach
2. Conservative approach
3. Aggressive approach.
1. Hedging or Matching Approach
• Hedging approach is also known as matching approach.
Under this approach, the business concern can adopt a
financial plan which matches the expected life of assets
with the expected life of the sources of funds raised to
finance assets.
• When the business follows matching approach, long-term
finance shall be used to finance fixed assets, and
permanent current assets and short-term finances to
finance temporary or variable assets.
2. Conservative Approach
• Under this approach, the entire estimated finance in
current assets should be financed from long-term sources
and the short-term sources should be used only for
emergency requirements. This approach is called as “Low
Profit – Low Risk” concept.
3. Aggressive Approach
• Under this approach, the entire estimated
requirement of current assets should be financed
from short-term sources and even a part of fixed
assets financing be financed from short- term
sources. This approach makes the finance mix more
risky, less costly and more profitable.
 CASH MANAGEMENT
• Cash is a medium of exchange, which allows
business to run their activities.
• Cash management is the art of synchronizing cash
receipts and cash payments for effective cash
management in a firm, i.e. it is concerned with the
managing of:
 Cash flows in to and out of the firm
 Cash flows within the firm, and
 Cash balances held by the firm at a point of time by financing
deficit or investing surplus cash.
• The basic objective in cash management is to keep
the investment in cash as low as possible while still
keeping the firm operating efficiently and effectively
(i.e., is reducing the idle cash amount).
• Cash management is a planning and controlling of level of cash to
achieve or accomplish the cash cycle at a minimum cost and to
maintain good liquidity. To do so, the aim of cash management
shall be:
 Maintaining adequate control over cash
 Keep the firm with liquidity
 Use some excess cash, which results in better profit.
• In addition the firm considers the following aspects of cash
management:
• Cash planning: is a technique to plan and control the use of cash.
Using cash budget, the firm should determine cash surplus and deficit.

• Optimum cash level: the firm should decide on the appropriate level of
cash balance, i.e. the cost of excess cash and the danger of cash deficit
should be considered to determine the optimum level of cash balance.

• Managing the cash flows: cash inflow must be accelerated while cash
outflow should be decelerated.

• Investing surplus cash: idle/surplus cash should be properly invested

to earn profit
CASH CYCLE (NET OPERATING CYCLE)
• It is the length of time which is working capital elapses
between payment for materials and the collection of cash
from customers.

Cash turnover = total annual outlay

Minimum cash balance
Cash turnover = number of days in a year
Cash cycle

• Minimum cash balance = total annual outlay * cash cycle

360 days
Example: ABC Company pays its A/P on the 10 th day after
purchase, the average collection period (ACP) for the firm is
30 days and the age of inventory is 40 days. The firm spent
Br 36,000 on operating cycle investment. But the firm wants
to stretch its A/P payment to 20 days and ACP wants to
reduce to 10 days. If the firm pays 12% for its financing
purpose per year,
determine;
A. The cash turnover.
B. The minimum cash balance for both alternatives.
C. Determine the annual cost of saving amount.
Alternative 1 Solution
Given: ACP (DCP) =30 days Cash cycle (net operating cycle) = (30+40) -10 = 60 days.

ICP (AAI) =40 days A. Cash turnover = 360 days = 6 times.

CDP (APP) =10 days 60 days
• The company has 6 operating cycles available within a year.
• N.B. cash turnover is equal to the number of operating cycles available within a
fiscal year.
B. Minimum cash balance = total annual outlay = Br 36,000 = birr 6,000
Cash turnover 6
Or 360 days = Br 36,000 X = Birr 6,000 -this is the minimum cash balance for one
60 days X operating cycle.

Total cash balance = Cash turnover * minimum cash balance = 6* Br 6, 000 = Br 36,000.
Alternative-2
Given: ICP = 40 days
DCP = 10 days
CDP = 20 days
CCC/NOC = (40+10)-20 = 30 days.
Solution
1. Cash turnover = 360 days = 12 times.
30 days

2. Minimum cash balance = Br 36,000 = Br 3,000

12

Or 360 days = birr 36,000 X = Br 3,000

30 days X
This minimum cash balance is reserved for only a single operating cycle. But we
consider the annual operating cycle, we do have Br 36,000 (total cash balance).
3. Cost of saving for holding excessive cash = 12% (Br6, 000-3,000) =12 %( 3,000)
= Br 360.
 REASONS/ MOTIVES FOR HOLDING CASH

• What are the rationales for holding cash?

• The primary reasons for holding cash by the
firm are the following:
Transactions requirement:
• A cash balance necessary for the day to day
operations of the firm. It refers to holding cash to
meet anticipated payments whose timing is not
perfectly matched with cash receipts.
Compensating balance:
• The amount of cash needed to meet certain
lending terms of commercial bank loans.
• Secondary reasons for holding cash are:
Precautionary balances:
• the amount of cash a firm needs to reserve for random,
unforeseen, unexpected contingency. These “safety stocks” are
called precautionary balances, and the less predictable the
firm’s cash flows, the larger such balances should be. However,
if the firm has easy access to borrow funds, i.e. if it can borrow
on short notice, its needs for these balances will be reduced.
Speculative balances:
• is the amount of cash hold to enable the firm to take advantage
of bargain purchases that might arise at any time. Relates to
holding of cash for investing in profitable opportunities as and
when they arise. the opportunity may arise in two situations:

• When the market price of the security decreases (change in

market price of securities) (Decrease price of bond, increase in
profit /return)-the firm will hold cash by expecting the price of
securities may fall and the interest may increase.
• The firm may also speculate all materials prices, i.e. if
the materials prices is expected to be reduced, then
the firm may be postponed its acquisition.

Advantages Of Holding Adequate Cash And Near-

cash Assets
• To take the advantage of cash or trade discount for
early payment of bills.
• To maintain a firm’s credit rating- by improving its
current and quick ratios (acid-test ratios).
• To take advantage of favorable business opportunities
such as special offers from suppliers or the chance to
acquire another firm.
• To meet such emergencies as strikes, fires or
competitors’ marketing campaigns, and to weather
seasonal and cyclical downturns.
 Objectives of Cash Management

• Cash management has two objectives:

1. To meet the payment schedule, i.e. to have sufficient
cash to meet the cash disbursement need of the firm.
2. To minimize cash balances a firm holds on to avoid
idle cash. Thus, the goal of the cash management is
to minimize the amount of cash, and at the same
time, to have sufficient cash for different reasons to
meet unexpected cash due to:
• A high level of cash balance will insure timely
payment of obligations and will enable the firm to
take advantage of opportunities. But it also implies
that large funds will remain idle, as cash is a non-
earning asset and the firm will have to forgo profits.
• A low level of cash balances on the other hand, may
mean failure to meet the payment schedule.
 CASH MANAGEMENT TECHNIQUES

• Effective cash management encompasses proper management

of cash inflows and outflows. There are some commonly used
cash management techniques. These include:
1. Cash flow synchronization
2. Using float
3. Speeding up cash collections (acceleration of receipts).
4.Slowing down disbursements (deceleration of payments).
1. Cash flow synchronization: is a situation in which
inflows coincide with outflows, thereby, permitting a firm to
hold low transactions balance.
2. Using float: float is the difference between the cash
balance shown in a firm’s check book and the balance on
the bank’s records.
• There are two types of floats:
• Collection float and
• Disbursement float and the difference between
the two is net float.
A. Collection float (receipt float): refers to the total
time lag between the mailing of the payment by the
payer and the availability of cash in the bank. The
cheque is received from a customer and it goes for
collection but the cheque is not cleared by the
paying bank, it is called collection float. The
collection float has three components:
I. Mailing float (mail delay):
• It is the time taken by the post office for transferring
check from the customer to the firm. It results from
the time that elapses from the mailing of the check
by the payer until the payee receives the check.
II. Processing float (processing delay):
• It is the time taken in processing the check with in the
payee and sending it to bank for collection.
III. Availability float (collection time):
• It is the time taken by the bank in collecting the
payment from the customer’s bank, which is a result
of the payee not being granted immediate availability
for use on all deposits. Collection time between one
bank and another and finally when it is credited to
the payee’s account he can use the money.
• Float is a function of both the time lag and the
amount involved.

• Float = time lag in days *amount of cash being

delayed
• Float: Difference between bank cash balance and
book cash balance
• Float= Firm’s bank balance- firm’s book balance
B. Disbursement floats: refers to the value of the cheques
that a firm has written but which are still being processed
and thus, have not been deducted from the firm’s bank
account balance by the bank.
• It occurs when the balance on the firm’s bank account
exceeds the one on the firm’s book. This occurs because of
delays caused by mailing, processing, and clearing of
disbursement cheques.
• It is experienced by the payer and it is a delay in the
actual withdrawal of funds.
• It has three components:
I. Mailing float: measured as the time between the payers’
mailing of the cheque and the payee’s receipt of it.
II. Processing float: is the time required by the payee to
deposit the cheques after it has been received.
III. Clearing float: is the time required by the banking
system to return the cheque and present it against the
payer’s disbursement account.
Disbursement float Collection float
• Checks written by • Checks received by
firm the firm
• Decreased in book • Increase in book cash
cash but no but no immediate
immediate change change in bank
in bank balance balance
3. Speeding up cash collections
• Financial managers have searched for ways of
collecting receivables in order to minimize the
amount of investment in receivables.
• Although cash collection is financial manager’s
responsibility, the speed with which cheques are
cleared also depends on the bank’s system. Several
techniques are now used both to speed up collections
thereby, reducing collection float and availing funds
where they are needed. These techniques include:
A. Prompt billing
B. Allowing discounts for earlier payments
C. Lock box system
D. Concentration banking
E. Decentralized collections
A. Prompt billing: an obvious but easily over looked way to
speed up collections of receivables is to prepare invoices
and send to customers promptly and accurately.
B. Allowing discounts for earlier payments: the
availability of discount is a good motivation to make
payments quicker. However, provision of a cash discount
is not a common practice in Ethiopia.
C. Lock box system: is the most important tool for
accelerating the collection of remittances. A company
rents a local post office box and authorizes its bank to
pick up remittances in the box. Customers are billed with
instructions to mail their remittances to the lock box. The
bank picks up the mail several times a day and deposits
the cheques directly in to the company’s account. The
cheques are recorded and cleared for collection.. The
company receives a deposit slip and a list of payments,
together with any material in the envelops.
• Advantages: Cheques are deposited before, rather than
after any processing and accounting work are done. Lock
box system eliminates processing float.
• Disadvantage: cost
D. Concentration banking: it is a collection procedure in
which payments are made to regionally dispersed
collection centers, when deposited in local banks for quick
clearing.
• It reduces collection float by shortening the mail and
clearing floats.
• The movement of cash from lock box or regional banks in
to the firm’s central cash pool residing in concentration
banking is known as cash concentration.
The process of cash concentration:
• Improves control over inflows and outflows of corporate
cash. The idea is to put all of your eggs (or in this case,
cash, in to one basket and then to watch the basket).
• Reduces idle cash: i.e. keeps deposit balances at regional
banks no higher than necessary to meet transaction
needs. Any excess funds would be moved to the
concentration bank.
• Allows for more effective investments: pooling excessive
balances provide the larger cash amounts needed for
some of the higher yielding, short-term investment
opportunities that require a larger minimum purchase.
E. Decentralized collections: a big firm operating over
wide geographical area can accelerate collections by using
the system of decentralized collections. A number of
collecting centers are opened in deferent areas instead of
collecting receipts at one place.
• Decentralized collection saves mailing and processing
time. Thus, it reduces the firm’s collection float. As a
result, funds will be available sooner for its own purposes.
4. Slowing down disbursements
(deceleration of payments):
• This is one objective of cash management to slow
down cash disbursements as much as possible. To this
effect, the firm’s objective, relative to its A/P, is not
only to pay its accounts as late as possible but also to
slow down the availability of funds to suppliers and
employees once the payment has been dispatched.
• A variety of techniques aimed at slowing down
disbursements, and thereby, increasing disbursement
float, are available. These techniques include:
A. Controlled disbursing: is the strategic use of
mailing points and bank accounts to lengthen mail
float and clearing float, respectively.
B. Playing the float: it is a method of consciously
anticipating the resulting float, or delay, associated
with the payment process and using it to keep funds
in an interest earning form for as long as possible.
C. Overdraft system: is an automatic coverage by the
bank of all cheques presented against the firm’s
account, regardless of the account balance.
D. Zero balance account: it is a checking account in
which a zero balance is maintained and the firm is
required to deposit funds to cover checks drawn on
the account only as they are presented for payment.
 INVESTING SURPLUS CASH IN MARKETABLE
SECURITIES
• Due to a close relationship between cash and
money market securities, management of cash
and marketable securities are interrelated.
• Many firms hold at least some marketable
securities in lieu of large cash balance because:
– They earn modest return than cash.
– They can be liquidated in short notice.
• Though marketable securities are held primary
for precautionary purpose, they can be used for
other purposes, such as transactions and
speculative balances.
• Since they earn less return than a firm’s
operating assets, it has to be properly managed.
Selecting criteria for investing in marketable
securities
• In choosing among alternative investments, the firm should
examine three basic features of securities.
• Safety: marketable securities that earn higher return and low risk
are chosen for investment opportunities, but the higher in return,
the higher default risk, low risk securities will earn low return.
• Maturity: the time period over which interest and principal are to
be made. The price of long term security fluctuates more widely
with the interest rate changes than the price of short term
security. For investing purpose, short term securities are
preferable.
• Marketability: refers to convenience and speed which a security
or an investment can be converted in to cash.
Types of short term investment opportunities :
Treasury bill
Commercial paper
Certificates of deposit
Bank deposits
Inter-corporate deposits
 MODELS FOR DETERMINING THE OPTIMAL LEVEL
OF CASH
• Costs arise from holding both too much and to little cash.
Any attempt to determine an optimal cash position involves a
tradeoff between the known costs of holding cash (or
opportunity or carrying costs) and there are of cash
shortages (shortage or adjustment costs). This problem of
determining the target cash balance is seen as a cash
minimization problem- minimizing the total cost of carrying
and shortage costs.
• In solving the problem of setting target cash balance,
there are some mathematical models. These are:-
1. BAUMOL‘S MODEL
• This model provides a formal approach for determining a
firm’s optimal cash balance under certainty.
• This model suggested that the point where the carrying
cost equal to the transaction cost is the optimal level
of cash balance.
Assumptions of the model:
• The firm is able to forecast its cash needs with certainty
• The firm’s cash payments occur uniformly over a period of time.
• The opportunity cost of holding cash is known and it does not
change over time.
• The firm will incur the same transaction cost whenever it converts
securities to cash.
• The firm incurs a holding cost for keeping the cash balance. It is an
opportunity cost i.e. the return forgone on the marketable securities.
• If the firm’s opportunity cost is “k”, then the firms holding cost for
maintaining an average cash balance is:
• Holding cost =k(c/2) c/2 is average cash balance
• The firm incurs a transaction cost whenever it converts its marketable securities
to cash.
Total number of transactions during the year = Total funds requirement (T)
Cash balance(c)
• The per transaction cost is assumed to be constant, if per transaction cost is
(t):
Transaction cost = t (T/c)
Total annual cost of the demand for cash will be:
Total cost= Holding cost + Transaction cost
= K(c/2) + t (T/c)
• The optimum cash balance (c*), is obtained when the total cost is
minimum.

C*=

Where, c* = optimum cash balance

t = cost per transaction
T = total cash needed during the year
K = opportunity cost of holding cash
• The optimum cash balance will increase in increase in the cost per
transaction and total funds required and decrease with the opportunity cost.
Example1: ABC Chemical limited estimates its total cash requirement
as Br 20,000,000 next year. The company’s opportunity cost of
funds is 15% per annum. The company will have to incur Birr 150
per transaction when it converts its short term securities to cash.
Required: Based on the above data, determine:
1. Optimum cash balance
2. Total annual cost of the demand for the optimum cash balance.
3. Number of deposits to be made during the year.
Solutions:
1. Optimum cash balance is given by
C* =

C* = = Br 200,000
2. The annual cost will be:
Total cost = holding cost + transaction cost
Total cost = k(c/2) + t (T/c)
0.15(200,000/2) + 150(20,000,000/200,000)
0.15(100,000) + 150(100)
15,000 + 15,000
Total cost = Br 30,000
3. During the year the company will have to make 100 deposits, i.e.
converting marketable securities into cash.

Transaction cost = per transaction cost * number of deposits.

Number of deposits = Transaction cost = Birr 15,000 = 100 deposits

Per transaction cost Birr 150
Example 2: a firm has the following information regarding to its cash
flows:
 Fixed transaction cost = Br 3 per transaction
 Monthly need for cash = Br 10,000
 Opportunity cost of cash = 8%.
Required: based on the above data, determine:
1. The optimum cash balance
2. The total costs for the optimal (target) cash balance.
3. Number of deposits to be made during the year.
2. The Miller-Orr Model
• Unlike the Baumol’S Model, this model assumes that
cash inflows and outflows fluctuate randomly on day to
day basis and hence the cash balance fluctuates randomly
up & dawn such that the average of the change is zero.

• This model operates with an upper and lower limit to cash

balance and a target cash balance falling in between the
two limits.
• It allows the cash balance to move between the upper and
lower limit, meaning, as long as cash is between the upper
and lower limit nothing will happen.
• However, when cash balance reaches the upper limit (U*),
for the excess of the upper limit over the optimal cash
balance, during this time, marketable securities are
purchased to reduce cash balance to the optimal level,
which is sometimes called the return point (optimum
level).
• On the other hand, when the cash balance reaches the lower limit (L*) for
the difference between the target cash balance and the lower limit
amount, marketable securities are sold to increase cash balance to the
return point or optimal level determined by the model.
• The operation of the model begins by setting the lower limit of cash
balance as a safety stock. Along with the transaction costs and
opportunity costs, the system needs the variance of the net cash of the
firm per period ( )

Upper limit

• Purchase of securities

Cash balance Return Point

• Sale of securities

Lower limit

Time interval
• According to the Miller-Orr model;
• R = (3/4 *Transaction cost * cash flow) 1/3

, and c* =L + Where,

C* = Optimum cash balance

F= fixed cost of security transaction
= variance of daily net cash flow
standard deviation
interest rate per day on marketable securities
return point
Lower limit.
Note: The variation of upper and lower limit at return point assumed
to be equal, the mean cash flow equals to zero (0). The net cash
flows at zero (0) mean and zero (0) standard deviation in the
normal distribution.
Upper limit = 3c*-2L or (U*) = L+ 3R
C* = L + R
Average cash balance = (4c*-L)/3
Example1: To demonstrate, assume that a firm pays Br 5 per
transaction to convert marketable securities to cash, interest rate is
2% per month and the standard deviations of the monthly net cash
flows is Br 300 assuming that the minimum cash balance is decided
to be Br 150.
Required: Determine,
1. The optimal cash balance
2. The upper limit(u*)
3. Average cash balance
• Solution: Variance ( ) = (300)2 = 90,000
F = Birr 5 I = 2%

R = Birr 256.50 Statistical control parameter.

1. C* = L + R = Br 150 + 256.50 = Br 406.50
2. U* = L + 3R or U* = 3C*- 2L
• U* = 150 + 3(256.50) or U* = 3(406.50) – 2(150)
• U* = 150 + 759.50 U* = 1219.5 – 300
• U* = Br 919.50 U* = Br 919.50
3. The average cash balance = (4C* - L)/3 = 94(406.50) – 150)/3 =
Birr 492.
 In both the Baumol and Miller-Orr models, it is true that;
1. The larger the interest rate, the lower is the target cash balance.
2. The larger the ordering cost, the higher is the target cash balance.

 It is also to be noted that the higher the variance of the net

cash flows or uncertainty,
1. The larger the difference between the upper and lower limits of
cash balance, and
2. The larger the optimal cash balance and the upper limit of cash
balance.
Exercise:
 The firm confirms that its cash flows satisfies the
Miller-Orr model of its annual interest rate of 25, the
standard deviation (δ) of its cash flow per day is Br
50,000 with a transaction cost of Br 45 per
transaction. The minimum cash balance of the firm is
Br 100,000.
Required: Determine;
A. Statistical control parameter.
B. Optimum return point (The optimal cash balance).
C. The upper control limits (UCL).
D. Average optimum cash balance.
SOLUTION:

A. R = Br 45,000

B. Optimum return point (The optimal cash balance)

C* = L + R = Br 100,000 + Br 45,000 = Br 145,000
C. UCL (U*) = L + 3R = Br 100,000 + 3(45,000) = Br 235,000
= C* + 2R = Br 145,000 + 2(45,000) = Br 235,000.
D. Average optimum cash balance = (4C* - L)/3
= (4(145,000) – 100,000)/3 = (580,000 -100,000)/3 = Br 160,000