Working Capital

You receive a letter from your utility company asking you to save time and money by giving them authorization to deduct your average monthly bill directly from your checking account. No checks to write, no stamps to find, and you will always know what amount will be deducted and the date of the deduction. Once a year, you will be billed or credited for the difference between your yearly average and what you actually used in gas and electricity. What could be easier? Why is the utility company being so nice? Do they really care about your time and budget? The answer is yes - and no. They are making an offer that will appeal to and benefit many consumers. But more important, from the utility's standpoint, is that this offer will also be a tremendous help to the company in an area that is important to every firm - cash management.

This week, we are going to look at the ways in which a company manages its working capital. Working capital consists of the firm's current assets of which cash and cash equivalents are the most important component. Many companies that have made profits over the years have failed because they did not manage their cash wisely.

Week In Relation to the Overall Course

You already know from last week the importance of creating and updating a cash budget because it lets financial managers know when there will be excess funds to invest and when borrowing will be needed. Now we will look at some techniques to help manage cash inflows and outflows. The techniques used to manage cash are important tools. Managing cash is one of the most important responsibilities of the financial manager.

Discussion of a Key Point, Thread, or Objective

Companies and individuals hold cash for three main reasons: to conduct transactions, for precautionary purposes, and to take advantage of speculative opportunities. They may also accumulate cash in preparation for payment of a future obligation, such as maturing bonds, or to meet the compensating balance requirements of their bank.

The transaction motive for holding cash is simply the need to pay the firm's bills, pay its employees, and pay its taxes. This is the main use of cash for most companies. Vendors will soon stop selling to a company if invoices aren't paid. Employees would soon look for another job if their paychecks stopped. The government will close a company down if they fail to pay their taxes!

The precautionary motive is equivalent to saving for a rainy day. Companies need to keep a minimum cash balance available as a safety net for unanticipated expenses.

Holding cash for speculation allows the company to take advantage of investment opportunities or to time anticipated investments, such as a merger, to its best advantage.

The basic rules of effective cash management are to collect amounts owed to the company as quickly as possible, to pay amounts owed by the company as slowly as possible, and to keep idle cash to a minimum.

There are many ways in which a company can assure that it has use of its cash as quickly as possible. One of the oldest techniques is the lock box. Lock boxes shorten the time between a customer mailing a check to the company and the company actually having use of the funds. This is done by eliminating float. When you write a check, money is not deducted from your account immediately. The money is withdrawn from your account only when the check is presented to your bank for payment. The time between the writing of the check and when it is presented to the issuing bank for payment is called float. There are different types of float. Mail float is the number of days it takes from the time a check is mailed until it reaches its destination. Processing float is the time it takes a check to go from a company's mail room through accounts receivable processing and finally be deposited in the firm's account. Check clearing float is the number of days it takes a check to go through the Federal Reserve check clearing system and be presented to your bank for payment. It is not uncommon for it to take a total of seven to ten days from the time a check is written to the time it is cleared. During that time, the money is not available for use by the firm. Lock boxes shorten mail and processing float. Banks often operate lock box operations. The customer mails payments to a post office box in a city close to his/her address. Usually, cities are chosen so that mail float is limited to only one or two days. The check is delivered to a processing center and immediately deposited into the firm's account. This eliminates processing float. The bank then sends the company a record of each day's payments, either in the form of a printout or electronically, so that the accounts receivable records can be updated. Using a lock box can eliminate three to five days of