Page 102 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 6: Managing Collection and Disbursement of Working Capital

6.3.3 Using Mathematical Models Notes

Formal mathematical models such as those mentioned above are useful for increasing our
understanding of the cash management problem and providing insights and qualitative guidance.
The models tell us which factors are important and make the trade-offs explicit.

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Caution Transaction costs play a central role. If transaction costs were zero, the firm would
require no working cash balance at all; it simply would sell securities or borrow to pay
every bill.

Are formal mathematical models also useful for quantitative applications? In practice, the cash
flow patterns of most firms are partly predictable and partly random. Neither the inventory
model nor the control limit model is strictly applicable. By combining the insights from formal
models with the techniques of cash budgeting and pro forma analysis, many firms can arrive at
reasonable answers by experience and experiment. In deciding how far to go in analysing the
problem, we must consider the cost of the analysis. Except in the case of very large firms,
quantitative solutions to the cash balance problem using formal mathematical models are likely
to be uneconomical. Often, the cost of obtaining the necessary input data and operating the
model exceeds the savings over solutions that can be attained by experience and experiment. As
always, we must keep an eye on the cost of our analytical techniques as well as on the benefits.

6.3.4 Planning Cash Requirement

In most cases, to search for the optimal working cash balance probably overstates our capabilities;
we must be content to get reasonably close. Perhaps we should substitute the word “appropriate”
for “optimal.”

The current account balance that the firm should maintain is the compensating balance
requirement or the optimal working balance, whichever is greater. Some firms, especially those
with seasonal sales patterns, may find that the appropriate working balance varies somewhat
over the year. As a firm grows, the appropriate working cash balance will also grow, although
probably not proportionally.
Once we have settled on the appropriate balance to be maintained in the current account, we can
integrate cash management into the financial planning process. The projected current account
balance goes into the pro forma balance sheet. Any excess cash over that figure may then be
invested in interest-bearing assets.

6.3.5 Investing Idle Cash

Cash in excess of requirements for working balances normally is invested in interest-bearing
assets that can be converted readily into cash. A firm might hold excess cash for two principal
reasons; first, the firm’s working capital requirement may vary over the year, perhaps in a fairly
predictable manner if the variation is due to recurring seasonal factors. From the pro forma
balance sheet, it was apparent that excess cash would build up during seasonal lows in accounts
receivable and inventory, and would be needed later to finance a re-expansion of receivables
and inventory during the next seasonal high. We can view the excess cash as a part of the firm’s
transaction balances. Even though the cash is temporarily idle, there is a predictable requirement
for it later. Second, excess cash may be held to cover unpredictable financing requirements. In a
world of uncertainty, cash flows can never be predicted with complete accuracy. Competitors
act, technology changes, products fail, strikes occur, and economic conditions vary. On the
positive side, attractive investment opportunities may suddenly appear. A firm may choose to

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