Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash

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Corporate Finance FIN 622

Lesson 28

CASH MANAGEMENT

The following topics will be discussed in this lecture.

Overtrading Indications & remedies

Cash management

Motives for Cash holding

Cash flow problems and remedies

Investing surplus cash

Inventory approach to cash management

Demerits.

Overtrading Indications & Remedies

In contrast with over-capitalization, overtrading occurs when a firm tries to do too much too quickly with

too little long term capital, so that it is trying to support too large trade volume with limited capital

resources.

Even a firm operating in profit may find itself in serious conditions because it is in short of money situation.

Such liquidity troubles emerge from the fact that it does not have enough cash to pay off debt as it falls due.

The major signs leading to overtrading are as follows:

- There is significant increase in turnover.

- Increase in current assets is rapid.

- Stock turnover the debtors turnover might slow down, in which case the rate of increase in

stocks and debtors would be even greater than the increase in sales.

- Payment to creditors is pushed to increase length.

- Short term loans are exceeding the limits and firm tries to negotiate increased limits.

- The current and quick ratio falls

- The firm leads to liquid deficit situation where current liabilities are greater than current

assets.

Overtrading takes place when a business accepts work and tries to fulfill it, but fulfillment requires greater

resources of people, working capital or net assets than the business has available to it. It is often caused by

unforeseen events such as manufacture or delivery taking longer than anticipated, resulting in cash flow

being impaired.

Overtrading is a common problem, and it often happens to recently started businesses and to rapidly

expanding businesses. Cash often has to leave the business before more cash comes into it. For example,

wages and salaries are usually payable weekly or monthly and there may also be other expenses that need to

be met promptly, such as telephone bills and rent.

Although you may pay suppliers on credit, your customers may also pay you on credit. It doesn't take much

to upset the balance.

Remedies

Effective debt management and credit control can help you avoid overtrading, by ensuring that you get paid

more efficiently and have the cash to pay suppliers and staff.

In addition to managing debt more effectively and improving credit control, you should also think about

changing some or all of your business practices.

Set New Payment Terms

You could renegotiate payment terms, or tell customers that new terms will apply for future orders, but you

should be aware that customers may object. Much will depend on the strength or weakness of your

competitive position. You may lose business if your new terms are unattractive to your customers, or if you

are aggressive in imposing them.

Offer Discounts for Prompt Payment

This can be effective in accelerating payment, boosting cash flow and reducing bad debts. However, there

are disadvantages - it can be expensive and must be policed to ensure that customers only take discounts

when they pay promptly. See our guide on invoicing and payment terms.

Use factoring or invoice discounting

Factoring involves selling your invoices to a specialist finance company which takes on the administration

and cost of recovering the invoice payments. With invoice discounting, you raise a loan from a finance

company against the value of your invoices, but you keep the responsibility and cost of recovering invoice

payments. See our guide on debt factoring and invoice discounting: the basics.

Corporate Finance FIN 622

Negotiate payment terms with your suppliers

You could try to negotiate different payment terms with your suppliers or you could just take longer to pay.

However, this may be considered unethical, and you may find that some suppliers refuse to supply you if

you habitually take too long to pay. You may therefore want to consider giving something in return for

extended payment terms, such as a promise of regular orders.

Cash Management

Cash is your business's lifeblood. Managed well, your company remains healthy and strong. Managed

poorly, your company goes into cardiac arrest.

If you haven't considered cash management an important issue, then you're probably undermining your

business's short-term stability and its long-term survival. But how can you manage business cash better?

Cash Flow Problems and Remedies

· Growth: a growing business needs to have more non current assets and these fixed assets must be

financed.

· Seasonal business: like on Eid and religious occasions, the business activity jumps manifolds and

firms need more cash to procure inventory etc.

· Capital expense or one-off expenditure.

· Losses increase the cash flow problems

· How to improve cash flow:

Cash flow problems can be handled in the following ways:

· decreasing the receipt float

· deferring capital expenditure (capex) and developmental work

· accelerating cash inflows which were set for recovery at a later period.

· liquidating investments

· deferring payments to creditors

· rescheduling loan payments

· planning is of immense importance especially rolling cash budgets.

Motives for Cash holding

Transactions Motive ensures that the firm has enough funds to transact its routine, day-to-day business

affairs. Safety Motive protects the firm against being unable to meet unexpected demands for cash.

Speculative Motive allows the firm to take advantage of unexpected opportunities that may arise

Estimating Cash Balances

The Baumol Model

ECQ = 2 x Conversion Cost x Demand For Cash

Opportunity Cost (In Decimal Form)

WHERE:

Conversion cost = cost of converting marketable securities to cash ($/conversion)

Opportunity cost = interest earnings given up due to holding funds in a non-interest-earning cash

Investing Surplus Cash

Companies may have surplus cash or some companies may be rich in cash and this leads us to think "what

to do with the surplus cash?" Obviously, the "surplus" here means temporary and it should be invested in

short term for earning return on it.

Before putting the surplus cash into any bank deposit, the firm will consider three factors:

- Liquidity company can withdraw the money out of deposit quickly and without the loss

of value.

- Profitability the deposit must offer good return for the risk being taken.

- Safety there's no chance of loss of deposit.

There are some other factors that need to be considered when investing of surplus cash is an issue. Keeping

in view the interest market it should be decided whether to put the money in a deposit bearing fixed or

floating interest rate, term to maturity and penalties for early liquidation of deposit in case, firm needs cash

for other purposes. Tax on profit and option of investing in international market should also be considered.

Corporate Finance FIN 622

Inventory Approach to Cash Management

The answer to question "how much cash should be held?" will vary firm to firm and business to business.

However, there are different models that can provide a relative guide as to how much cash a company

should hold.

We can identify two types of cost that are involved in obtaining cash. First is the fixed cost that may be in

terms of issuing new shares or negotiating a new loan. Second is the cost that represents the opportunity

cost of keeping the money in the form of cash. This is variable portion of the total cost of cash holding. If

you don't put the surplus money into earning, you are loosing money.

Inventory approach uses the same equation as of economic order quantity. We here reproduce the EOQ

equation with slight change.

Q = √ 2 FS / i

Where:

S = is the amount of cash to be used in each period

F = fixed cost of obtaining new funds

i = interest cost of holding cash

Q = quantity of cash to be held per period.

Drawbacks of inventory approach:

- to predict cash requirement is not a simple task. Normally, it cannot be determined with

certainty.

- There are costs associated with running out of cash which are not considered by this

approach.

- The other normal cost of holding cash that increases with amount held is ignored.

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