Working capital and treasury management

The working capital comprises of receivable, cash, inventory and payables

Balancing Liquidity and Profitability
The management of working capital is concerned with the liquidity position of the company. A
business’s liquidity determined its ability to survive. Si at the time of need, company should quickly
turn the working capital in cash. Again in this, the company’s profitability should not be undermined.
Company should manage the each element of working capital by trading of liquidity and profitability
Element of WC Liquidity Profitability
Cash High cash to pay debt & get discount High yielding investment of cash
Receivable Less credit or short credit period Short of sales revenue
Inventory Cost of broken production facility Cost of holding inventory
Payable Hold creditor for some month Loosing source of supply
(Profit and cash flow are not same)
Short term finance and long term finance for working capital
(Figures from book)
 Some permanent current assets are financed by short term credit – More profitable but riskier
 All permanent and some fluctuating current assets are financed by long term credit – Less profitable but
less risky
Making the working capital financing decision
Business may be categorised as having aggressive, average or defensive position.
(Example from book)
Aggressive company which have more short term credit than equity, returns a higher profit but less liquidity
Average company will have less risk and comparatively less return than the aggressive company
Defensive company sacrifices profitability for liquidity using a very small amount of short term credit.

Assessing liquidity position via ratios: Inventory turnover, receivable collection period, payable collection
period, current ratio, quick ratio, etc. –(described in earlier Chapter)
Cash operating cycle/working capital cycle
It focuses the length of time between a business paying out cash for inputs and receiving cash for goods sold. It
is measured in days.
(Calculation of cash operating cycle in book)
Solution to the liquidity problems
 Reducing the inventory holding period
 Reducing the production period
 Reducing customer credit
 Extending the period of credit taken from suppliers
Managing Inventory:
Profitability Vs liquidity
Higher inventories may give higher sales Higher inventories mean more finance is needed
Reason for holding inventory
 Meet demand acting as a buffer
 Ensure continuity of production
 Take advantage of quantity discount
 Buy ahead of a shortage
 Reduce ordering cost
 Seasonality of demand
 Minimum order quantity
 Special promotions offered
Cost associated with inventory
 Purchase price
 Holding cost
 Re-ordering cost
 Shortage cost
Inventory control systems:
 Re-order level system
 Periodic review system
 ABC system
 EOQ
 JIT Manufacturing system
 Perpetual inventory method
 Managing trade payables:
Trade credit is a chief source of finance. However trade credits are not without cost for the following reason:
 Credit status may be lost and the supplier will give low priority in future orders
 The supplier may rise the price to compensate the finance
 The buyer may loose any cash discount for prompt payments
Advantage of trade credit:
 It is convenient and informal
 It can be used by businesses which do not qualify for credit from a financial institution
 It does not prevent advantage being taken of settlement discounts
 It can be a sales promotion device
 It can be used on a very short term basis to overcome unexpected cash flow crisis

Managing Trade Receivable:

The management of trade receivable involves the business trading off
 The cost of extending credits to customers (Finance costs, irrecoverable debts and admin cost for credit
control department)
 The benefits of granting credit (larger profit at the increased sale for credit term offered)
Credit control and collection policies:
1. Credit term and settlement discount: Credit term can be changed and must respond to the competition,
new markets, etc. But they will be influenced by trade customs. Settlement discount are again
influenced by custom and practice within the industry
2. Credit rating: The risk that a customer will not pay its debts can be indicated by giving such customer a
credit rating. Customer who pays on time are given high credit rating, but those who pay slowly are
given a lower one. Credit rating should be reviewed regularly. Credit rating should be based on
 Ability of the customer to meet the liability
 An assessment of financial statements
 The use of credit rating agency
 An analysis of ongoing trading experience
Financing trade receivables:
1. Invoice discounting: This involves selling the invoices to a discounting company for a cash sum, then
repaying the discounter when the debtor pays the invoice
2. Receivable factoring: Three element of factoring
 Accounting and collection: the business is paid by the factor as customer settles their invoice
or after an agreed settlement period.
 Credit control: The factor is responsible for chasing the customers and speeding up the
collection of debts
 Finance against sales: the factor advance
Good practices in receivable management:
1. Look after key accounts
2. Manage or reduce time scale between placement of an order and receipt of the cash from customers
3. Issue credit note promptly
4. Pay commission to the sales person on cash collected
5. Set target for receivable days or percentage overdue account

Treasury Management:
Business must trade of the cost of holding cash against the cost of running out of cash
Motives of holding cash
 Transaction motives
 Finance motives
 Precautionary motives
 Investment motives
Aim of good cash management:
1. Accurate cash budgeting/forecasting
2. Planning short term finance- receivable factoring, Bank OD, short term bank loan, operating lease
3. Planning investment of surplus when necessary- treasury bill, deposits, bonds, equity, gilts.
4. Cost efficient cash transmission- General clearing by cheques, clearing house automated payment
systems, bank automated clearing system
Banking system: the banking system comprises of primary and secondary banks.
Primary bank are those which operates money transmission service in the economy. They operates cheque
accounts and deal with cheque clearing
Secondary bank are made up of wide range of merchant banks and other banks. They donot tend to take part in
the clearing system.

The bank customer relationship:

 Debtor creditors relationships
 Bailor/ bailee relationship
 Principle /agent relationship
 Mortgagor/mortgagee relationship
 Fiduciary relationship

Money markets: These are a vast array of markets buying and selling different form of money and marketable
securities. The main traders of money markets are bank, the government (through the Bangladesh bank), local
authorities, brokers and other intermediaries.
The money market financial instruments are
 Bills
 Deposits
 Commercial papers

Sample questions from Chapter9 Working capital and treasury management

1. What do you mean by liquidity and profitability? Why these are to be trade off for all the elements of
working capital
2. Describe aggressive, average and defensive working capital. If a company moves from a defensive
working capital policy to an aggressive working capital policy, what will be the change in risk and return?
3. What do you mean by cash operation cycle? If a business is suffering from liquidity problems, the aim
must be to reduce the length of the cash operating cycle. How you can reduce the cash operating cycle?
4. Calculation of cash operating cycle.
5. What do you mean by overtrading? How can you avoid this in business?
6. What are the different systems of inventory control systems? Please describe ABC system, or JIT
manufacturing system or perpetual inventory method.
7. Describe trade credit. What will happen of it is not managed properly?
8. Describe how you can control trade receivable.
9. Describe how you can finance trade receivable.
10. What are the good practices in receivable management?
11. What are the motives of holding cash?
12. Describe treasury management. How you can manage treasury?
13. Describe different relationships between Bank and the customers.
14. Questions in interactive questions.