Chapter 13 • Management of working capital
especially where the particular commodity is one that is vital to continuing operations,
such as labour. Failure to meet a financial obligation to a lender puts that lender into
a position where it could take steps to instigate the defaulting business’s liquidation.
Given the bankruptcy costs and an inefficient market for real assets, the possibility of
such an outcome must be a matter of great concern to shareholders seeking to increase
or at least to maintain their wealth. A shortage of cash could expose the business to the
risk of liquidation.Loss of opportunities
Cash shortages tend to mean that it may be impossible to react quickly to an oppor-
tunity. For example, if a business is offered a contract that must be fulfilled at short
notice by overtime working, it may have to be refused if cash is not available to meet
the additional labour costs. Thus a shortage of cash exposes the business to the risk of
incurring opportunity costs.Inability to claim discounts
Discounts for prompt payment are very advantageous, in percentage terms, to the
purchasing business. Cash shortages may preclude claiming such discounts.Cost of borrowing
Shortages of cash will expose the business to the risk of having to borrow on a short-
term basis to be able to meet unexpected obligations. Interest costs for such borrow-
ings can be expensive, particularly where the money has to be raised at very short
notice and under pressure.As ever, optimally balancing these two types of cost and risks is the aim of the finan-
cial (treasury) manager. There are some models that can be helpful in this task.Cash management models
Several cash management models have been developed. The simplest one is substan-
tially the same as the economic inventories order quantity model that we derived on
page 363. This cash model assumes that the business keeps all of its cash in an inter-
est-yielding deposit account from which it can make withdrawals as it needs. It also
assumes that all receipts (from trade receivables and so forth) are put straight into the
deposit and that cash usage is linear over time, following exactly the same pattern as
Figure 13.4 (page 362) does for inventories. The model derives the amount of money
to withdraw from the deposit so that the costs of withdrawal are optimally balanced
with those of interest, etc., forgone by holding cash, rather than leaving the funds on
deposit. The model can be stated asC=
where Cis the optimum amount of cash to be withdrawn each time, Wis the cost of
making each withdrawal (a cost independent of the size of the withdrawal), Pis the