Page 107 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Self Assessment

Fill in the blanks:
7. Ending balance = Beginning balance + ………………… – Disbursement
8. Determining the appropriate working balance in the face of non-synchronous but
predictable cash flows is a problem of minimising ………………
9. The current account balance that the firm should maintain is the compensating balance
requirement or the…………………………., whichever is greater.

6.4 Summary

Steps to improve the efficiency of collection and disbursement must focus on the cash
cycle of the firm. Concentration accounts can be used to reduce the requirement for working
balances.
Collection time can be reduced by the use of a lock-box system. Disbursements should be
made within credit term but no sooner than required.
A working cash balance is required for various business purposes so its adequacy is very
important for the business.

Determination of the optimal level of working cash balance is a sine qua non for efficient
business operations. In some cases, bank compensating balance requirements may
determine the minimum working balance. Where this is not the case, finding the optimal
balance involves a trade-off between transaction costs (high for low working balances)
and opportunity costs (high for high working balances).
By combining the qualitative insights from theoretical models with techniques such as
cash budgeting and proforma analysis most firms can arrive at reasonable answers with
some experimentation.
Firms hold liquid assets over and above working-balance requirements for two main
reasons: as temporarily idle transaction balances to meet the transaction requirements
and as precautionary balances. Vehicles for investing such cash reserves should be evaluated
on the basis of default risk.
Maturity, marketability and yields on such short-term money-market instruments vary
over the business cycle and tend to average slightly less than those of longer-maturity
issues.

6.5 Keywords

Default risk: Default risk refers to the possibility that interest or principal might not be paid on
time and in the amount promised.
Managing working capital: Managing working capital means controlling the collection,
disbursement, and investment of cash. When it comes to managing working capital, time is
money.
Marketability: Marketability refers to the ease with which an asset can be converted into cash.
Maturity: Maturity refers to the time period over which interest and principal payments are to
be made.

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