Page 99 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Since current accounts earn no interest, it is to Neptune’s advantage to leave only the amount
necessary to operate, and to invest the remainder temporarily in interest-bearing liquid assets
until needed.
Our problem, then, is to determine how much cash a firm should maintain in its current account
as a working balance.

The working balance is maintained for transaction purposes like paying bills. If the firm maintains
too small a working balance, it may run out of cash. It then must liquidate marketable securities,
if available, or borrow. Liquidating marketable securities and borrowing, both involve
transaction costs.
If, on the other hand, the firm maintains too high a working balance, it foregoes the opportunity
to earn interest on marketable securities, that is, it incurs what economists refer to as an
‘opportunity cost’. Thus, the answer we seek is the optimal working balance, rather than the
minimum. Finding the optimum involves a trade-off of transaction costs against opportunity
costs. If a firm tries to keep its working balances low, it will find itself selling securities (and
later repurchasing securities) more often than if it aims at a higher level of working balances,
that is, transaction costs fall as the working balance level rises. Opportunity costs, on the other
hand, rise as the level of working balances rises. There is one point where the sum of the two
costs is at a minimum as shown in Figure 6.3. This is the optimal level of working balance that
efficient management should try to find.

Figure 6.3: Optimal Level of Working Balance

6.2.2 Compensating Balance Requirements

If a firm uses bank credit as a source of financing, the question of the optimal current account
balance may have a simple answer: it may be dictated by its compensating balance requirements
to compensate for various services such as processing cheques and standby commitments to
lend.

In some cases, a firm may determine with very little analysis that its optimal working balance
is below the bank’s compensating balance requirement. In such cases, the latter figure becomes
the firm’s minimum current account balance. In other cases, where the answer is not so clear or
where compensating balances are not required, we must put pencil to paper to determine the
appropriate working balance.

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