o CFM 6thEd StudyText Chapter10

Working capital andcashmanagement

chapter 10

learning outcomes

After reading and understanding the contents of this chapter and working through all the

worked examples and practice questions, you should be able to:

� Understand the importance of managing working capital.

� Use measures to monitor working capital and cash.

� Understand the causes of cash shortages and the actions that can be taken to deal

with them.

� Recognise cash management models.

� Identify options for short-term funding, including those introduced in earlier chapters.

� Understand the role of the treasury function.

� Be aware of the range of short-term investment options for surplus funds and the criteria

used to choose between them.

� Discuss the significance of interest rates and be aware of the ways in which interest rate risk

can be managed.

contents

1 Working capital

2 Ratios associated with the assessment of

working capital

3 Overtrading

4 Cash management

5 Management of short-term finance

6 Treasury function

7 Short-term investments

8 Interest rates

9 Debt portfolio management

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164 WORKING CAPITAL MANAGEMENT

Introduction

Funds employed in an organisation can be split for planning purposes into long-termand short-term funds.As we have seen in earlier chapters, the financial manager willattempt to match the funding available to the business to the life of the investment itis required for. In this chapter we shall consider themanagement of short-term fundsapplied to funding current assets.

1 Working capital

Working capital is the total amount of cash tied up in current assets and current liabil-ities and is calculated by deducting the total amount of current liabilities from thetotal amount of current assets. Thus, if A plc has current assets of £10 million andcurrent liabilities of £6 million, then its working capital resources are £4 million.The finance needed to fund a firm’s required level of working capital can be either

short- or long-term.It is essential to ensure that a firm has sufficient working capital to allow it to

operate smoothly and have sufficient funds to pay its bills when they arise (takinginto account the effects of inflation). However, an organisation should be careful notto over-provide working capital and cause unnecessary cost, a phenomenon knownas ‘overcapitalisation’.

1.1 OvercapitalisationOverinvestment in working capital leading to excessive stocks, debtors and cash,coupled with few creditors, is known as overcapitalisation. Such a situation will leadto lower return on investment and the use of long-term funds for short-term assets.Indicators of overcapitalisation include long debtor and stock turnover periods, highliquidity ratios and a low sales/working capital ratio.

1.2 Rate of turnover of working capitalAn organisation needs to control the rate of turnover of working capital constituents.While reducing the rate of turnover reduces the level of working capital required, itmay lead to overtrading (see later). The rate of turnover of working capital can bedetermined by calculating the working capital cycle (also called an operating cycle,trading cycle or cash cycle), which shows the relationship between investment inworking capital and cash flow.The following is an example of a typical working capital cycle for a manufacturing

company:

Rawmaterials in stock 20 daysWork-in-progress 21 daysFinished goods stock 38 daysPeriod between despatch and invoice to customer 10 daysPeriod from invoicing to customer payment 60 days

Total 149 days

Less period of credit taken from suppliers 60 days

Working capital cycle 89 days

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Of course, wages and other expenses would have to be paid during the period. Stepstaken to speed up the rate of working capital turnover (e.g. reducing stock levels orimproving debtor control) will reduce the company’s investment in working capital.To illustrate this point, let’s look at worked example 10.1.

10 WORKING CAPITAL AND CASH MANAGEMENT 165

worked example 10.1

A company sells £20 million of goods throughout the 50 weeks of the working year. As sales are partly throughretail outlets and partly through mail order, daily sales from Monday to Friday can be considered to be equal.The firm banks its takings on Thursday of each week and the incremental cost of banking is £50. Thecompany’s account is always overdrawn and it pays interest on this overdraft of 15 per cent p.a. (in thisexample to be applied daily on a simple interest basis).

Required

Management wishes to know whether there will be a benefit to banking twice weekly on Monday and Thursday.Investigate the possibility.

Answer

£20 million over 50 weeks of the year gives a turnover of £400,000 per week and £80,000 per day for a five-day week.

We will now assess the banking alternatives being considered:

Day Receipts Banking Thursday Monday & Thursday

Days interest ‘£ days’ Days interest ‘£ days’ £000s£000s charged £000s charged

Monday 80 3 240 0 0

Tuesday 80 2 160 2 160

Wednesday 80 1 80 1 80

Thursday 80 0 0 0 0

Friday 80 6 480 3 240

960 480

Banking only on Thursday has the same effect as having an overdraft of £960,000 for one day each week. Interms of interest, the cost of this is:

£960,000 × (15% ÷ 365) × 50 = £19,726.*

The annual interest cost of banking twice weekly is:

£480,000 × (15% ÷ 365) × 50 = £9,863.*

(*For interest purposes, we are using a calendar year.)

Annual incremental banking costs at £50 per time are:

Once weekly, 1 × £50 × 50 = £2,500, twice weekly, (2 × £2,500) = £5,000.

The total cost of banking on Thursdays only is:

£19,726 + £2,500 = £22,226.

Banking on Mondays and Thursdays costs:

£9,863 + £5,000 = £14,863, a saving of £7,363 p.a., assuming constancy of all the factors.

There is an even better solution, still banking twice weekly. Can you decide what it is?


If such an exercise was to be conducted over a period of several years, thendiscounted cash flows (see chapter 12) would be used.

2 Ratios associated with the assessment of workingcapital

In attempting to control working capital a financial manager will use ratios; however,unlike someone external to the company he will not be restricted by balance sheetfigures, but will be able to monitor the ratios continuously.The main ratios that the financial manager will use in this area are the current

ratio, quick ratio and acid test ratio.The current ratio (or working capital ratio) is measured as:

current assets–––––––––––––– expressed as a ratio, e.g. 2:1.current liabilities

While there is a target ratio of 2:1, the acceptability of the ratio calculated willdepend on the nature of the business, but current liabilities exceeding current assetsgenerally indicates that the business may have problems. In common with all ratios,it is important to monitor this trend to ascertain whether there are potential prob-lems developing.


worked example 10.1 continued

Answer

Day Receipts Banking

Tuesday & Friday£000s Days Interest Charged ‘£ days’ £000s

Monday 80 1 80

Tuesday 80 0 0

Wednesday 80 2 160

Thursday 80 1 80

Friday 80 0 0––––

320––––

The calculation is as follows:

£320,000 × (15% ÷ 365) × 50 = £6,575

and the total cost is:

£6,575 + £5,000 = £11,575

An alternative way to compare the different banking methods would be to count the number of days interest ischarged. Interest is charged when the money is with the business and not in the bank. Paying takings in morequickly reduces any overdraft and with it overdraft interest, as well as reducing the risk of loss or theft.

The summary of the days’ interest is as follows:

Banking Thursday 12 days

Banking Monday and Thursday 6 days

Banking Tuesday and Friday 4 days

current ratio A ratiomeasuring short-termliquidity.



The quick asset ratio removes those items which cannot easily and quickly beconverted into cash at their full value (i.e. stock) and is calculated as:

current assets – stock––––––––––––––––current liabilities

Again there is no ideal ratio; what is acceptable depends on industry practice, thecompany’s relationships and contractual agreements with creditors and debtors, andthe company’s working methods.The acceptability of the one calculated depends onthe industry, although the target is 1:1. In addition, it is the trend over time that isimportant.The acid test ratio is the amount of cash which the firm has to service its current

liabilities and is measured as:

cash + deposits + quoted investments––––––––––––––––––––––––––––––

current liabilities

Again, it is the trend that is of most importance.Companies with poor acid test ratios need to have standby overdraft facilities to

ensure that the short-term need to service payments of current liabilities can be met.However, too much cash will mean that the firm is underutilising its resources andthat a better return could be available elsewhere.

3 Overtrading

Overtrading occurs when a company grows rapidly without an adequate increase inits long-term capital to fund its increased working capital requirements. Mostcompanies have a positive figure for working capital.When they grow, the increasedlevel of sales is accompanied by higher levels of stocks and more credit extended tocustomers.The value of credit received from suppliers probably also increases withthe volume of business, but the net effect of growth is that more cash needs to beinvested in working capital.If the increase in sales is permanent, the extra working capital should be funded by

extra permanent, long-term capital – either equity or long-term debt. If it is not,increased investment in stocks and debtors will bemet by a disproportionate increasein short term creditors or a deteriorating cash balance.Relations with suppliers may become strained and the costs of purchases tend to

rise because the company no longer qualifies for prompt payment discounts or doesnot qualify for discounts for quantity because cash shortages force it to buy in smallquantities. Eventually trade creditors may cut off supplies.Relations with bankers are also strained, particularly if increases in borrowing are

not planned or the company exceeds overdraft limits.Before this happens, relations with customers may also be affected if the company

fails to provide a full range of goods because it cannot afford to adequate stocks, orpresses customers for payment.On the other hand, if the failure to manage cash efficiently is also matched by a

failure to manage debtor and stock balances, stocks and debtors may rise, possiblyeven faster than turnover.Profit margins may be reduced, either because of increased purchasing costs or

because it offers discounts to encourage its customers to pay early. But a company thatis overtrading may still be trading profitably when it becomes insolvent.The symptoms of overtrading are illustrated by the following example:

quick asset ratio A measureof liquidity that removesthose items that cannoteasily and quickly beconverted into cash at theirfull value (i.e. stock).

acid test ratio Ratioshowing the amount of cashor near-cash that a firm hasto meet currentliabilities.



Year 1 Year 2£ £ £ £

Fixed assets 80,000 120,000Current assetsStock 20,000 45,000WIP 20,000 50,000Debtors 50,000 80,000Cash 5,000

95,000 175,000Current liabilitiesCreditors 45,000 118,000Bank 20,000 38,000

65,000 156,00030,000 19,000

–––––––– ––––––––110,000 139,000–––––––– ––––––––

Financed by:Share capital 100,000 100,000Profit & loss account 10,000 39,000

–––––––– ––––––––110,000 139,000–––––––– ––––––––

Year 1 Year 2£ £

Sales 500,000 1,000,000Cost of sales 400,000 875,000

–––––––– ––––––––Gross profit 100,000 125,000Gross profit margin 20% 12.5%Net profit 30,000 27,000Net profit margin 6% 2.7%

The important points to note are:(a) Strong growth in sales and falling profit margins.Turnover has doubled,

but the gross profit margin has fallen. Discounts for quicker paymentmay have caused this, as could lower sale prices to win more orders, orhigher unit costs as materials are bought in smaller quantities.

(b) Net profit margin shows a big decline. Increased wages and bonuses, orwriting off obsolete stock may have caused this.

(c) An increase in stocks in relation to throughput.Turnover has doubledfromYear 1 toYear 2, but the total value of stock andWIP has more thandoubled.The stock turnover ratio, calculated as:

stock days =stock × 365––––––––––cost of sales

has risen from 36.5 days to 39.6 days.(d) Although sales have risen by 100 per cent, the increase in debtors is only

60 per cent.The debtor days, calculated as:

debtor days =debtors × 365––––––––––––

sales

have fallen from 36.5 days to 29.2 days.(e) Surplus cash fromYear 1 has been used and bank borrowing has

increased.(f ) Creditors have increased by 162 per cent for a rise in turnover of 100 per cent.

Credit days, calculated as:

creditor days =creditors × 365––––––––––––purchases


If the bank limit is reached, no more trade credit is available and debtors areunwilling to pay more quickly, the firm could go out of business despite a full orderbook and the potential to be successful.Actions to relieve the situation could include:

� faster debt collection (although too much pressure may lose customers);� more efficient stock control;� slower payment to creditors, but there are limits that will be acceptable;� increased bank financing, although the bank will probably expect a capital injec-tion from outside the business as well;slowing down the rate of growth in turnover, allowing work in progress to befinished and stock sold, thereby reducing the amount of working capital needed.

Perhaps most importantly, the company needs to increase its permanent capital tomatch its increased investment in fixed assets and the increase in its working capital,which is likely to be permanent. Since all its long-term capital is equity capital, withno long-term borrowing, the company may be well placed to raise long-term debtcapital: it has assets to provide security, its fixed assets and current assets suggest thatit may be in manufacturing or wholesaling and could have steady income. Its busi-ness is profitable, and it may have sufficiently large and steady cash flows to coverinterest comfortably (though the information provided does notmake this clear).Onthe other hand, the growth in profits suggests that it would probably be well placedto issue more ordinary shares.


have risen from 41.1 days to 47.9 days. (Cost of sales has been used to representPurchases.This is often done when calculating creditor days to provide a figurethat can be compared with other companies, since published financial statementsshow cost of sales but may not show purchases.) There could be problems withfuture supplies if the increased credit from suppliers has not been negotiated.(g) The increase in fixed assets may not be related to the increase in turnover.The

expenditure may be part of a planned cycle and it is possible that some of theincreased business volume might have been achieved through higherproductivity using the existing fixed assets. It is unwise increase capitalexpenditure using short-term finance such as trade credit and bank overdraft,which is what seems to have happened here.

(h) The current and quick asset ratios have fallen, indicating a worsening in theshort-term financing position.

(i) The increased bank overdraft means that gearing has increased.The propri-etors’ stake (shareholders funds as a percentage of total assets) has fallen from62.9 per cent to 47.1 per cent:

Year 1 Year 2£ £

Total assets 175,000 295,000––––––– –––––––

Financed by:Shareholder funds 110,000 62.9% 139,000 47.1%Creditors 45,000 25.7% 118,000 40.0%Bank overdraft 020,000 11.4% 38,000 12.9%

––––––– –––––––175,000 295,000

test your knowledge 10.1

What are the symptoms of overtrading?



4 Cash management

Supplier credit represents a legitimate, and usually very important, source of businesscredit. However, every organisation must have adequate cash resources (includingundrawn bank overdraft facilities) available to meet the financial commitments ofday-to-day trading (e.g. wages and taxation). Cash is also required to meet contin-gencies, to take advantage of discounts and other opportunities available and tofinance expansion. Firms should avoid holding too much cash with the resultingunderutilisation of resources.The quality of working capital management can makethe difference between survival and failure, by ensuring that the firm always hassufficient funds to pay what it owes and avoid liquidation. Time spent in creditcontrol can be as important as time spent developing new business.

4.1 Cash flow planningTo understand cash management you need to be aware of the difference betweenprofits and cash flow. From your accountancy studies you will be aware that profit isthe amount bywhich income exceeds expenditure when both arematched on a timebasis. Cash flow, however, is the actual flow of cash in and out of the organisationwith no adjustments made for prepayments or accruals.A business which has insufficient cashmay be forced into liquidation by its unpaid

creditors even if it is profitable. Profitability and liquidity are complementary, and areboth crucial.While planning and controlling the use of resources to achieve prof-itability is essential for a company’s long-term success, planning and controlling theuse of cash to achieve liquidity may be essential for the company’s short-termsurvival.A lack of cash can be seen in increasingly late payment of bills. Managers need to

plan and control cash flows to ensure liquidity, so that the company can pay what itowes. In the short term this is done by cash flow budgeting, which can be daily,weekly, monthly or yearly, ensuring that the organisation has sufficient cash inflowsto meet its outflows as they become due. Such budgets should fit in with the overallbudgetary scheme that the company operates. If a shortage is expected, then the firmcan arrange finance, perhaps by increasing its overdraft.(We covered strategic cash flow planning and strategic fund management dealing

with longer-term cash flow planning in chapter 2.)Other remedies that can be used to deal with short-term expected cash

shortages are:

� accelerating cash inflows from debtors;� postponing cash outflows by delaying payment to creditors. While this isconsidered to be a cheap alternative (creditors rarely charge interest), such analternative increases the risk of insolvency of the firm;

� postponing capital expenditure (or negotiating extended payment terms with thesupplier);

� reversing past investment decisions, such as selling non-essential assets;� rescheduling loan repayments (with the lender’s agreement);� reducing the level of dividend to be paid;deferring tax payments (after discussion with the HM Revenue & Customs).Therewill be an interest cost.

Despite it being bad policy to finance long-term assets with short-term funding,where the financial manager can determine from the cash budget that sufficientfunds will become available, it may be possible to operate such a policy withoutdetriment to the firm.To help cash management of groups, a facility called ‘cash pooling’ may be

requested from the group’s bank.The process of cash pooling allows the offsetting ofsurplus and deficits held at the bank by the group’s companies using a dummy


account.The net balance is the one on which interest is payable or receivable and thegroup can then decide how to allocate this cost or income.For groups which have overseas subsidiaries involved in intra-group trading, the

group may net off the transactions between its members on a multilateral basis.While there are some countries which limit or prohibit netting (e.g. Italy andFrance), the groups should benefit from reduced transaction costs.A further method of cash management that may be adopted by a multinational

firm is to centralise cash management, holding funds in one of the major financialcentres such as London or NewYork, with only the minimum level required for day-to-day purposes being held by subsidiaries. The remittance of funds back to theparent can be done via the group’s bank, or telegraphic transfer, but there maybe limitations imposed by overseas governments on the level of remittances (seechapters 16 and 17).

4.2 Margin of safetyNo forecast will ever be 100 per cent accurate and the further into the future theprojections are made, the greater the margin of error. In cash budgeting the balanceat the end of each period represents a margin of safety, whereby the company buyspeace of mind at the expense of profitable utilisation of cash.The size of the balancemust be related to the certainty or otherwise of the predicted inflows and outflowsand the availability of back-up resources, such as overdraft facilities. A cash-basedbusiness, such as a food supermarket, will be more certain of its cash inflows than abusiness selling principally on extended trade terms. Where cash inflows can bepredicted with greater accuracy,margins of safety can be smaller.

4.3 Cash management problemsThere are several reasons why a business may encounter problems with its cash flow:

� Overtrading,which we discussed earlier in this chapter.� Growth: a firm may need to finance new assets to replace old and obsolete ones.� Loss-making: if a business continually trades at a loss for a protracted period cashproblems will materialise.

� Inflation: the replacement costs of stock will be at a higher price when there isinflation; however, competitive pressure may prevent a corresponding increase inselling price.

� Payment delays: either due to the business’s inefficiency or external delays.� Bad debts: a large customer going into liquidation can create severe problemswitha company’s cash flow.

� Large items of expenditure: fixed asset purchases or the redemption of loans candrain cash resources rapidly if insufficient plans have been made.

� Seasonal trading can cause short-term difficulties, particularly if a retailer’s stocks,bought in specially for seasonal trading (e.g. Christmas), prove unpopular and donot sell.

A company experiencing problems with its cash flow should ensure that the invoicedepartment is informed immediately when goods are despatched and that terms ofpayment are made clear.



What can a company do if its cash budget gives advance warning of impendingcash shortages?


4.4 Cash ratiosRatio analysis can help in cash management and serve as an indicator of the cash-holding position.The main ratios are the following.

Cash holdingThis ratio indicates the proportion of current assets which are held as cash.Generally,the financial manager will want to keep this figure at the safe minimum to be able toservice immediate current outflows.The ratio is measured as:

cash––––––––––––current assets

and may increase when a business is deliberately accumulating cash to meet futureneeds, e.g. capital expenditure or repayment of debt capital.

Cash turnoverThis is used to determine how frequently cash is turned over and is expressed as:

sales during the period––––––––––––––––––average cash balance

The ratio assumes that an average cash holding is used, typically calculated as:

opening cash balance + closing cash balance–––––––––––––––––––––––––––––––––––

2However, note that cash flows will not be constant, especially if there is seasonaltrade. For example, if sales for the year were £72,000 and the average cash holdingwas £9,000 then using the above formula:

sales during the period=72,000

= 8 times, i.e. cashwas turned over every 45.6 days.–––––––––––––––––– ––––––average cash balance 9000

A higher rate of cash turnover will generally be taken to imply the effective use ofcash – the more frequent the turnover, the lower the level of cash needed. High ratesof turnover, however, will appear as the result of maintaining too low a level of cashand as such these ratios should be viewed together, i.e. the maximum turnover rateconsistent with adequate holdings levels.Any proposed measures of improving cashflow management must be carefully evaluated to ensure that the costs do notoutweigh the benefits.Cash-based ratios varywidely in different industries, e.g. turnover of cash in a food

supermarket will be rapid, but in a major engineering concern it may take months toturn over once.Viewing one set of ratios for just one period will in itself disclose verylittle about the management of the firm and its trading prospects; calculated ratiosshould be compared both over time and with industry norms.

4.5 Factors affecting cash resourcesThe amount of cash an organisation is holding can be affected by a number ofunforeseen events:

� New competitors and/or new products may adversely affect demand for acompany’s products.

� Consumers may change their purchasing habits, e.g. people are becoming increas-ingly aware of benefits derived from the use of environmentally-friendly products.




� Upward movements in interest rates will reduce the amount of cash available tofirms that are in a net borrowing situation.

� Businesses involved in international trade will be affected by movements inforeign exchange rates.

� Strikes or disasters may halt production, or at least significantly reduce it, with aresultant fall in sales volume.

There is often a considerable amount of money tied up in the ‘float’, i.e. the processof converting the cheque sent by the debtor into cash in the creditor’s bank. Delaysduring the process are those in receiving the cheque (transmission delay) and inlodging and clearing it. The use of systems such as bank giro, BACS (Bankers’Automated Clearing Services), standing orders, direct debits and CHAPS (ClearingHouse Automated Payments System) help to reduce these delays. In addition, acompany could collect local cheques itself and should certainly ensure that chequesare banked on the day of receipt whenever possible.

4.6 Cash management modelsA number of models have been developed to help companies manage their cash.These range from simple spreadsheets to more complicated models such as theMiller-Orr model (see below).The aim of theMiller-Orr model is to trade off the lossof interest involved in holding idle cash balances against the risk of having insuffi-cient cash.The model sets optimal minimum and maximum levels of cash holding.When these levels are reached the firm either sells or buys short-term marketablesecurities to adjust the cash levels. To set these levels, the variability of cash flowsneeds to be determined together with the costs of buying and selling securities andthe interest rate.The steps in using the model are:

(a) Determine the lower level of cash the firm is happy to have.This is generally set ata minimum safety level, which in theory could be zero.

(b) Determine the variance of the firm’s cash flows (perhaps over a three- or six-month period).

(c) Calculate the spread of transactions, using the following formula:

Spread� 3 ×3

(d) Calculate the upper limit (the lower limit plus the spread).

(e) However, to minimise the costs of holding cash, securities should be sold when apre-calculated level (the return point) is reached.The return point is the lowerlimit plus a third of the spread.

(0.75 ×Variance of cash flow ×Transaction cost)��

Interest rate

worked example 10.2

Pat Ltd faces an interest rate of 0.5 per cent per day and its brokers charge £75 for each transaction in short-term securities. The managing director has stated that the minimum cash balance that is acceptable is£2,000 and that the variance of cash flows on a daily basis is £16,000.

Required

What is the maximum level of cash the firm should hold and at what point should it start to purchase or sellsecurities?


The Miller-Orr model is useful in that it considers:

� the level of interest rates (higher rates give a narrower spread, so less cash needs tobe held before the return point and the upper limit is reached);

� transaction costs (higher transaction costs increase the spread and thereforereduce the number of transactions);

� variability of cash flows (more variable cash flows allow a greater degree offreedom for cash levels).

A drawback of the model is that it assumes that cash flows vary randomly and doesnot take account of the fact that some cash flows (for example, dividend payments)can be predicted accurately.

5 Management of short-term finance

We have seen that short-term finance is a major source of working capital and that itcan be obtained from a variety of sources,most of which we have already discussed:

� bank overdrafts;� the issuing of short-term debt instruments (for larger companies);� taking trade credit from suppliers;� using factoring or invoice discounting to obtain cash against debtors (see chapter 11).

There are two more methods that you need to know about.

5.1 Bills of exchangeThe cost of trading transactions may be settled by means of bills of exchange (alsocalled trade bills): the seller draws a bill on the buyer asking him to pay, on a certainfuture date, the price of the goods; the purchaser accepts the bill of exchange by signingit and returning it to the seller, thus formally acknowledging his debt to the seller.Theseller can then use the bill of exchange as security to obtainmoney from his own bank.


Answer

Following the above procedure:

(a) Determine the lower level of cash the firm is happy to have – this has been set at £2,000.

(b) Determine the variation in cash flows of the firm – this has been found to be £16,000.

(c) Calculate the spread of transactions:

Spread � 3 �3

Spread � 3 �3

= £1,694

(d) Calculate the upper limit – this is the sum of the lower limit and the spread:

Upper limit – £2,000 + £1,694 = £3,694.

(e) Securities should be sold when the return point is reached. The return point is the sum of the lowerlimit and a third of the spread:

Return point = £2,000 + 1/3 (1,694) = £2,565.

Thus the firm is aiming for a cash holding of £2,565 (the return point). Therefore, if the balance of cashreaches £3,694 the firm should buy £3,694 – £2,565 = £1,129 of marketable securities; if it falls to£2,000, then £565 of securities should be sold.

(0.75 � 16,000 � 75)��

0.005

(0.75 � Variance of cash flow � Transaction cost)��

Interest rate



A bank may also agree to accept a bill from its customer in exchange for an agree-ment that the customer will repay the bank.The cost for arranging this finance is thediscount (i.e. the full amount of the bill is not advanced).The more secure the bill(e.g. from a bank as compared to a trader) the ‘finer’ or lower the discount.This method is a common source of finance for international trade (see

chapter 16).

5.2 Acceptance creditsThis is a facility offered by banks for large companies with a good reputation.Thecompany draws bills of exchange on the banks, generally for 60, 90 or 180 days,denominated inwhichever currency best matches the needs of the company.The billscan be drawn on, as and when required, throughout the length of the agreement,which can be for up to five years, provided the credit limit is not exceeded.The bill isthen sold in the discount market and the proceeds passed to the company (less thebank’s commission).At maturity, the company reimburses the bank the full value ofthe bill and the bank pays the holder of the bill.A major advantage of acceptance credits is that they can be sold at a lower discount

than trade bills.Their cost is also fixed, allowing for easier budgeting.They may costless than an overdraft at times of rising interest rates.Unlike an overdraft, the credit isguaranteed for the length of the agreement.

6 Treasury function

In chapter 2 we discussed the role of the treasurer,which involves budgeting for cashflows, procuring adequate liquid funds, managing interest rate risk and the physicalsecurity of cash resources. In a business that operates internationally, the treasuryfunction will also include foreign currency management. In some organisations thetreasurer or treasury department may also be involved with:

� setting corporate financial objectives;� raising finance;� mergers, acquisitions and demergers;� dividend policy;� listing on the stock exchange;� pension fund investment management;� insurance;� risk management;� the provision of general financial advice.

The treasurer will be actively interested in taxation matters as these will often impacton the products and services used by his department.An important area of the treasury function’s work is working capital and liquidity

management.While individual operating units will often arrange their ownworkingcapital needs through local banks, reports of facilities arranged, level of utilisation,interest and other charges, etc., will be collated and controlled from the centraltreasury function.The treasurer will be actively involved in full liquidity control; this includes all

areas of activity that have an impact on cash flow.The treasury function can be centralised or decentralised.The key advantages of

having a centralised treasury function are:


List the possible sources of short-term finance.


1 The centralised nature of the function amalgamates all borrowing and surplusfunds so that improved banking terms can be negotiated on deposits and onborrowing; this will amply cover the cost of the treasury function.

2 It simplifies the number of accounts with outstanding balances to the credit ordebit of the organisation.

3 Treasury staff have the time and expertise to deal in highly technical markets.4 Foreign currency risk can be managed more effectively by a centralised treasurydepartment, which has a better view of the company’s total exposure.

However, if cash management is decentralised:

1 It will be more responsive to the needs of the individual operating units, althoughbecause of the reduced size the opportunities to invest surpluses or raise deficitswill be more limited.

2 The sources of funds can be used to match the currency of assets (see chapters 16and 17).

3 Subsidiaries will manage their cash balances more assiduously if they are respon-sible for them.

7 Short-term investments

We have seen that firms may have a surplus of cash, either deliberately to meetpurchase costs in the near future or to take advantage of high interest rates, or becauseof higher than expected profit levels or a lack of investment opportunities.These fluc-tuations can arise for a variety of reasons, a major one being seasonal fluctuationsin trade.A short-term surplus of funds should be invested in short-termmarketable securi-

ties. Treasurers will employ surplus funds to obtain the best possible returns withmaximum security. In evaluating the alternatives a variety of factors must be takeninto account including:

� risk;� liquidity;� term;� cost;� return;� accessibility – deposits with banks, finance houses and local authorities are onlyaccessible when the term finishes – debt instruments and equities can, however,be sold when cash is needed;

� type and level of interest rate;taxation;

� complexity;� minimum/maximum criteria;� image/policy.

Investment opportunities which are available include:

� money market deposits;� treasury bills;� equities;� commercial paper;� bonds;� gilts;



� certificates of deposit;� bank and other financial institution deposits, the interest rate varying with theinstitution, the type of account and the amount deposited;

� longer-term debt instruments;� Eurocurrency deposits;� finance house deposits;� local authority deposits;� sterling bankers’ acceptances (bank bills);� local authority bills;� bills of exchange (trade bills).

8 Interest rates

Interest rates are an important element of the economic environment and influencethe foreign exchange value of a country’s currency, as well as acting as a guide to thesort of return shareholders might want and expect.Changes in market interest yields, therefore, affect share prices. Every financial

instrument has its own interest rate or range of rates.The most common quoted ratesinclude:

(a) Base rate – the ‘bottom line’ rate set by the Monetary Policy Committee of theBank of England. Most lending to individuals and smaller and medium-sizedenterprises is at certain margins above base rate.

(b) LIBOR – the London Inter-Bank Offer Rate at which banks lend to each other.Large and multinational companies’ lending is often tied into these morefavourable LIBOR rates.

(c) Treasury bill rates – the rate at which the Bank of England sells treasury bills to thediscount market and a good indicator of longer-term rates as these bills will notbe redeemed for some years.

(d) Gilts yield – rates attached to government securities and a good indicator oflonger-term rates.

8.1 Why so many rates?The reasons include:

� risk – a higher risk must be compensated for by higher returns (i.e. higher interestcharges);

� need for profit – the ‘spread’ between savings and lending-based productsprovides the intermediaries’ profit;

� duration of lending – long-term loans yield a higher return than short-term ones;� size of loan – economies of scale and negotiating strength all have a part to playhere;

� international rates – domestic rates will be influenced by speculators’ behaviourand the movements of funds internationally.

Borrowers have different risks of default and this is reflected in the differences in theinterest rates they are expected to pay, e.g. the government will pay a lower rate ofinterest on its borrowing than a small, new company.The additional return requiredwill be equal to the fall in expected value of the investment taking into considerationthe default risk.We can see this by considering an example.




8.2 Market segmentation theoryThis theory simply acknowledges that the demand for financial products can besegmented into a number of types. There is great variety of financial instruments.Different products are designed for different purposes and the interest charges are afundamental part of the overall package.

8.3 Interest rate structureInterest rate (as discussed above) depends on the date to maturity of the product, e.g.treasury stock might be short-,medium- or long-dated.The term ‘interest rate structure’ refers to the way in which the yield on a type of

security varies according to the term (length) of the borrowing period.When interest rates are low it might be advisable to:

� borrowmore, increasing the company’s gearing at lower fixed rates;� borrow for longer terms;� pay back loans with higher rates or roll them over for loans of lower rates.

Alternatively, when interest rates are high it might be advisable to:

� substitute equity for debt finance and reduce the company’s gearing by investingsurplus cash in short-term interest-bearing securities;

� borrow short-term rather than at long-term rates, which may be even higher, butin any case avoid a long-term commitment to high rates.

When interest rates change, the return expected by shareholders will change too. If ashareholder expects, say, a 10 per cent return on his investment and the annual divi-dend per share is 15 p, then (ignoring any capital growth) themarket value of a shareshould be:

15p––––= £1.5010%

worked example 10.3

Jim plc’s 10% loan stock is redeemable, at par, in 12 months’ time. The current price of the loan stock, onwhich annual interest for last year has just been paid, is £76.86 per £100 nominal. The market price reflectsa general belief that there is a 20% chance that Jim will default on payment and there will be no return for theloan stockholders.

Required

Calculate the yield on Jim’s loan stock and comment on what you find. Ignore taxation. (The return ongovernment stocks is 5 per cent.)

Answer

The expected payment for £100 of nominal of the loan stock after 12 months (based on £100 redemption ofcapital plus £10 interest, with a probability of 80%):

(0.8 × £110) + (0.2 × 0) = £88

So the expected rate of return is:

£88/£76.86 – 1 = 0.145 = 14.5%

The expected return is higher than that on government stocks to compensate investors for the risk of default.


If interest rates rise (to 12 per cent, say) the shareholder will equally expect a higherreturn for his shares and the price will have to fall (assuming that dividends remainconstant) as follows:15p–––––= £1.2512%

A final point to note is that because of movements in the capital value of the invest-ment, an increase in interest rates will lead to market values dropping.As an example, if you hold (undated) gilts with a coupon rate of 3.5 per cent at a

time when the market rate of interest is 3.5 per cent, the market value of your invest-ment will be equal to the face value of the gilts, say £100.If interest rates rise to 5 per cent their market value will drop:

3.5%£100 × –––––= £70

5%

If interest rates drop to 2.5 per cent their market value will rise:

3.5%£100 × –––––= £140

2.5%

9 Debt portfolio management

An important part of the treasury function is the management of the debt the firmholds in its portfolio.The treasurer needs to consider:

(a) The relative proportion of fixed and floating rate debts – the increasing costs ofvariable rates when interest rates are rising need to be weighed against theopportunity cost of holding fixed rate debt when interest rates are falling.

(b) The mix of currencies which debts are held in and the possibility of loss due toadverse movements in foreign exchange rates.

(c) The maturity of the debt – the repayment of debts needs to be managed to allowa steady stream of repayments.

9.1 Interest rate riskOnemajor area which the treasurer needs to deal with is interest rate risk – the possi-bility that a change in interest rates can have a significant impact on the company’sprofits.Methods of reducing risk are often called hedging.This is an agreement withanother party who either has the opposite risk to you, or is a speculator wishing tomake a profit. This other party bears your risk. The costs to the firm are profitsforgone if the outcome of the risk has been positive and/or a fee to the other party.There are a number of financial instruments to accommodate the treasurer’s need

to reduce risk.The most common are the following.

SmoothingThis is the process of creating a balance between fixed and floating rates.

Interest rate swapsThis is an agreement between two parties by which each agrees to pay the other’sinterest, based on the underlying notional amount (there is no exchange of the prin-cipal sum) and for an agreed period.The parties must accept counterparty risk in thatthey are still obliged to ensure that their original lender is paid by the due date.Different interest rates apply, e.g. parties may swap fixed rate LIBOR payments forvariable LIBOR payments, or payments may be made between the parties to reflectthe different interest rates available to them,but the net effect will be that both partiesare better off as a result of the swap.


hedging The externalmanagement of risks, wheretwo or more parties make anagreement in which theirrisks cancel each other out.This is used in areas outsidethe company’s control, e.g.exchange rate and interestrate risk.

interest rate swaps Anagreement between twoparties under which eachagrees to pay the other’sinterest, based on theunderlying notional amount(there is no exchange ofthe principal sum) for anagreed period.


Swaps are often used by speculators and companies because they are easy andcheap to arrange (with only legal fees to pay) and are flexible as to size and duration.

OptionsAn interest rate option is the right to deal at the strike rate (an agreed interest rate)at some future, predetermined maturity date, at a cost known as a premium.At theexpiry date the option holder will decide whether or not to exercise it depending onthe difference between the interest rate of the option and the prevailing interest rates.Options tend to be more expensive than forward rate agreements (see below).Options can be purchased tailor-made from the larger banks and include:

� interest rate guarantee – a short-term option used for single transactions, valid forup to one year;

� interest rate cap – this puts a maximum rate on the transaction and can relate to anumber of transactions over several years;

� interest rate floor – this sets a minimum rate below which interest rates will notfall and is the converse of the cap;

� interest rate collar – this establishes both a maximum and aminimum rate outsidewhich nomovements will occur, or alternatively within which rates remain fixed.

Interest rate futures options giving the purchaser the right to buy or sell (call or putoptions) a futures contract, during a specified period, at a predetermined price, aretraded on LIFFE (London International Financial Futures and Options Exchange)which deals in long-, medium- and short-dated securities such as those listed aboveand those we discuss in the section on financial futures below.

Forward rate agreements (FRAs)These contracts provide for rates to be fixed in advance for a specified periodcommencing at some agreed future date; the difference between the actual rates andthose set will be paid to the company by the bank, or vice versa, depending on thedirection of interest rate movements.The rate set generally reflects the bank’s expec-tations of future rates. Unlike futures (see below), which are highly standardisedcontracts, FRAs can be tailored to meet individual needs, though they tend to be onlyavailable for up to 12 months and on loans of £500,000 or more. FRAs are entirelyseparate from the principal amount of the loan or deposit, relating only to theinterest element.

Financial futuresFinancial futures are contracts that are similar in outcome to FRAs.They are fixed interms of rate, delivery period and amount, and provide an interest rate commitmentfor a future period that is agreed at the outset. Common futures are gilt-edged stocks,Japanese,German and US government bonds, euro interest rates and short-term ster-ling.The market for futures is LIFFE (the London International Financial Futures andOptions Exchange) (see chapters 3 and 17).A form of security deposit known as a margin is required from a purchaser, who

may also be required to make variable payments reflecting daily changes in thefutures’ price (known as variation margins).The minimum movement permitted ina financial futures contract is known as the tick.The price of a futures contract is set at£100 less the prevailing interest rate.Interest rate futures are limited in that they must be for a standard amount, but

they are a popular means of speculation, there being no requirement for the specu-lator actually to be a borrower or lender of the amounts of the contract and many ofthe contracts are settled in cash rather than the supposed underlying security.They arealso popular with financial institutions, which are not as concerned with a perfectmatch against exposure.


interest rate option Theright to deal at the strikerate (an agreed interest rate)at some futurepredetermined maturitydate. At the expiry date theholder of the option willdecide whether or not toexercise it depending on thedifference between theinterest rate of the optionand the prevailing interestrates.

forward rate agreement(FRA) A contract thatprovides for interest rates tobe fixed in advance for aspecified periodcommencing at some agreedfuture date. The differencebetween the actual rates andthose set will be paid to thecompany by the bank or viceversa depending on thedirection of interest ratemovements. The rate setgenerally reflects the bank’sexpectations of future rates.

financial future An interestrate contract similar inoutcome to a forward rateagreement. It is fixed interms of rate, delivery periodand amount, and providesan interest rate commitmentfor a future period that isagreed at the outset.Common futures are basedon gilt-edged stocks.



Fixed forward interest contractsFixed forwards are agreements to borrow or deposit an agreed amount for a fixedterm commencing from a future date, but with the rate determined at the outset.These are covered in more detail in chapter 17.

MatchingHere, borrowing and deposits are linked to the same interest base. This provides adegree of cover and an alternative way of hedging.

SwaptionsThis is a hybrid instrument, which consists of an option to purchase an interestrate swap.

worked example 10.4

Clock plc has just taken out a six-month $500,000 12 per cent Eurodollar deposit. Interest rates are expectedto rise over the next six months. The futures price is 85, reflecting a yield of 15 per cent. To minimise theimpact of interest rate movements, the company sells a six-month Eurodollar contract (it makes a commitmentto take a deposit).

Required

If the spot rate gives a yield of 18 per cent at 30 June, what are the costs or savings to Clock and what is thehedge efficiency?

Answer

The cost savings is the profit arising from the ability of the company to buy back the future at a cheaper costthan it paid (i.e. 100 – 18, or 82). The profit is:

85 – 82$500,000 × (–––––––) × 6/12 = $7,500

100

The new interest cost is 3 per cent lower than if the hedge had not been used. There is thus a saving of:

3$500,000 × –––– × 6/12 = $7,500

100

If we compare this with the interest rate increase which would otherwise have been borne

6($500,000 × –––– × 6/12, or $15,000),

100

we can see that the hedge efficiency (the degree to which exposure to risk is covered or removed) is50 per cent.


(a) List the possible sources of short-term finance.

(b) How can a company reduce interest rate risk?

fixed forward interestcontract Agreement toborrow or deposit an agreedamount for a fixed termcommencing from a futuredate, but with the ratedetermined at the outset.

matching Borrowing anddeposits are linked to thesame interest base. Thisprovides a degree of coverand a way of hedging againstinterest rate variations.

swaptions A hybridinstrument which consists ofan option to purchase aninterest rate swap.


chapter summary

� We have looked at the definition of working capital, its

constituent parts and its relationship to fixed capital. We

have considered the financial management implications

of working capital and cash management and explained

some common ratios used in the management of working

capital in general and cash in particular.

� Balance in cash flow management is very important: too

little cash resources highlights impending danger, but too

large a reserve of cash will reduce profitability.

� The financial manager must predict the needs of the

business and make suitable funding or investment

arrangements..

practice questions

Section A (4 marks each)

10.1 Describe the ratios that are important to the financial manager’s control of:

(a) working capital;

(b) cash.

10.2 What is overtrading and how may it arise?

10.3 How can a company overcome problems that have resulted from overtrading?

10.4 Explain the significance of cash in financial management, and how a company can protect itself against the

consequences of liquidity problems of its customers.

10.5 List the functions of treasury management.

10.6 Suggest, giving your reasons, four financial figures that a company might monitor, and what it might look for in these

figures, to give it warning of possible overtrading.

10.7 State the purpose of the treasury function in a multinational company, and identify the activities that it is likely to

undertake.

10.8 Identify one measure of liquidity that a financial manager may use. State how it is calculated and comment on how

useful it may be.

10.9 Using the following information about a manufacturing company, calculate the working capital cycle (assuming 365

days in a year):

Value £

Finished goods stocks 149,040

Trade debtors 876,720

Trade creditors 455,880

Sales £8.0 million

Cost of sales £6.8 million

Material purchases £5.2 million



Section B (20 marks each)

10.10 It has been suggested that ‘cash is the lifeblood of business’. Discuss this statement from the point of view of the

financial manager in a dynamic, growing, unlisted company.

10.11 (a) Compare the problems of cash management with those involved in the management of other elements of

working capital. Outline the role of the treasury function in cash management, and state what actions may be

taken by other financial managers to deal with short-term cash shortages.

(b) A manufacturing company has the following information relating to its working capital and rates of turnover and

throughput:

Components of working capital Value

£

Raw material stocks 17,810

Work in progress 24,660

Finished goods stocks 37,260

Period between despatch and invoice to customer 2 days

Trade debtors 219,180

Trade creditors 113,970

Measures of annual turnover and throughput:

Sales £2.0 million

Cost of sales £1.7 million

Material purchases £1.3 million

Required

Calculate the working capital cycle (assume 365 days in a year, and assume that the value of work in progress is

equal to the cost of material plus half of the cost of converting materials into finished goods).



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