WORKING CAPITAL MANAGEMENT PART-2

In the part 1 of working capital management we tried to understand the concept and importance of working capital management. Now in this part we try to understand how to manage individual components which constitute working capital.

Treasury Management: meaning

Treasury management is defined as 'the complete handling 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'. The treasury management deals with working capital which constitute cash management, asset liability mix and Financial risk management which includes forex and interest rate management. The key goal of Treasury management is planning, organizing and controlling cash assets to satisfy the financial objectives of the organization, to maximize the return on available cash, minimize interest cost or mobilize as much cash as possible for corporate ventures.

Functions of Treasury Department:

1. Cash Management: The efficient collection and payment of cash both inside the organization and to third parties is the function of the treasury department. The treasury may simply advice subsidiaries and divisions on policy matter viz., collection/payment periods, discounts etc. Treasury will normally manage surplus funds in an investment portfolio. Investment policy will consider future needs for liquid funds and acceptable levels of risk as determined by company policy.
2. Currency Management: The treasury department manages the foreign currency risk exposure of the company. The use of matching receipts and payments in the same currency will save transaction  costs. Treasury might advice on the currency to be used when invoicing overseas sales. Forward contracts can be used to minimize risk.
3. Funding Management: Treasury department is responsible for planning and sourcing the company's short, medium and long term cash needs.
4. Banking:  Treasury department carry out negotiations with bankers and act as the initial point of contact with them. Short term finance can come in the form of bank loan or through the sale of commercial paper in the money market.
5. Corporate Finance:  Treasury department is involved with both acquisition and divestment activities within the group.

Management of Cash

For survival of business it is very necessary that there should be adequate cash. Finance manager has to ensure that all parts of organization have sufficient liquidity on the other hand he has to ensure that there are no idle funds as such funds entail a great deal of cost in terms of interest charges and in terms of opportunity cost.

Lord Keynes outlined three basic needs for cash

• Transaction needs: Cash is needed to meet day-to-day expenses and to pay other debts.
• Speculative needs: Cash is needed to take advantage of profitable opportunities.
• Precautionary needs: Cash may be held to act as for providing safety against unexpected events.

Cash management is concerned with the managing of cash inflows and outflows, cash flows within the firm and cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Company's these days manage it's cash affairs in such a way as to maintain a minimum balance of cash and to invest the surplus immediately in profitable investment opportunities. In order to synchronize the cash receipt and payments the firm has to do cash planning, manage cash flows, maintain optimum cash level and invest the surplus cash.

Cash Planning:

It is technique to plan and control the use of cash. This protects the financial conditions of the firm by developing a projected cash statement from a forecast of expected cash inflows and outflow for a given period. It may be done periodically either on daily, weekly or monthly basis. The very first step in this direction is to estimate the requirement of cash by preparing cash flow statement and cash budget.

Cash Budget:

This is the most significant device to plan for and control cash receipt and payments. This represents cash requirements of business during the budget period. It enables the firm to arrange finances and utilize funds in better ways. However it's less reliable due uncertainty of cash forecasts and also it fails to highlight the significant movements in the working capital items.

These tools help the management to pin point the time of excessive cash or shortage of cash.

Methods of Cash Flow Budgeting

Cash flow budget is detailed budget of income and cash expenditure incorporating both revenue and capital items. Cash budget is concerned with liquidity must reflect changes between opening and closing debtors balances and between opening and closing creditors balances as well as focusing attention on other inflows and outflows of cash. A cash budget can be prepared in the following ways:

• Receipt and payment method: In this method all the expected receipts and payments for budget period are considered. All the cash inflow and outflow of all functional budgets including capital expenditure budgets are considered. Accruals and adjustments in accounts will not affect the cash flow budget. Anticipated cash inflow is added to opening balance of cash and all cash payments are deducted from this to arrive at the closing balance of cash.
• Adjusted Income method: In this method the annual cash flows are calculated by adjusting sales revenues and cost figures for delays in receipts and payments and eliminating non-cash items such as depreciation.
• Adjusted Balance Sheet method: In this method, the budgeted balance sheet is predicted by expressing each type of asset and short-term liabilities as percentage of the expected sales. The profit is also calculated as a  percentage of sales, so that increase in owners equity can be forecasted. Known adjustments, may be made to long-term liabilities and the balance sheet will then show if additional finance is needed.

A firm can conserve cash and reduce its requirements for cash if it can speed up its cash collection which can be done by following methods

Concentration Banking: The company establishes a number of strategic collection centers in different regions instead of a single collection center at the head office. Payments are received these centers and are deposited in respective local banks which in turn transfers all surplus funds to concentration bank of head office. This system reduces the period between the time a consumer mails in his remittances and the time when they become spendable with the company.

Lock Box System: This system eliminates the time between the receipt of remittances by the company and deposited in the bank. Here company rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers are billed with instructions to mail their remittances to lock boxes. The bank picks up these cheques in company's account. The company receives a deposit slip and list of all payments together with any other material in the envelope. Here company is free from handling and depositing cheques. The main drawback of this system is its cost. Lock box arrangements are usually not profitable if average remittance is small.

Float

The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process.

Billing float is the time between the sale and the mailing of the invoice.

Mail float is the time when cheque is being processed by post office, messenger service or other means of delivery.

Cheque processing float is the time required for the seller to sort, record and deposit the cheque after it has been received by company.

Banking processing float is the time from the deposit of the cheque to the crediting of funds in sellers account.

A firm can increase its net float by speeding up collections. It can also increase the net float by delayed disbursement of funds from bank by increasing the mail time. A company may make payment to its outstation suppliers by a cheque and send it through mail. The delay in transit and collection of cheque, will be used to increase the float. The firm should make payments using credit to the fullest extent.

Cash Management Models

The models can be put in two categories- inventory type and stochastic model.

William J. Baumol's Economic Order Quantity Model:

According to this model, optimum cash level is that level where the carrying cost and transaction costs are the minimum. This model is used where cash flows are predictable. the formula is

C = { (2U * P) / S }^0.5

Where

C= optimum cash balance

U= Annual ( or monthly) cash disbursement

P= Fixed cost per transaction

S= Opportunity cost of one rupee p.a. ( or p.m.)

Miller-Orr Cash Management Model

According to this model the net cash flow is completely stochastic i.e. random. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the return point; and zero as lower limit. When the cash balance reaches the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When it touches lower limit, a transfer from marketable securities account to cash is made. during the period cash balance stays between high and low limits no transaction of cash and marketable account is made. These limits are set up on the basis of fixed cost associated with the securities transaction, the opportunity cost of holding cash and the degree of likely fluctuation in cash balances. These limits satisfy the demands for cash at the lowest possible total cost. This model is more realistic since it allows variations in cash balance within lower and upper limit.