Chapter 13 • Management of working capital
being granted. Where overdrafts are being used, as in our example, to overcome
temporary shortages of cash, this is probably not a problem since ‘immediately’, in
practice, probably means at a couple of months’ notice. To the business seeking to use
a bank overdraft as a more permanent source of finance, this can be a serious problem,
however.
Despite this problem, many businesses are financed partially by overdraft, on a
permanent basis. The overdraft remains at call, but is not repaid. To such businesses,
the overdraft represents a relatively cheap, but risky, source of finance.Short-term cash surpluses
Where the business is experiencing cash surpluses, normally evidenced by a build-up
of cash in its current account, it will be necessary to determine whether this cash
represents a permanent surplus or a temporary one. If it is a permanent one, con-
sideration will need to be given to using it in some ‘long-term’ manner. This should
involve further investment, if positive NPV projects can be found, or the repayment of
some long-term finance, if they cannot.
Where the cash surplus seems to be a temporary one caused, for example, by the
seasonality of the business’s trade, steps need to be taken to use it in the most effective
way. Possible options include the following:l Putting the cash on an interest-yielding deposit. Generally, higher returns accrue from
deposits requiring a period of notice of withdrawal, perhaps 30 days. Care must
therefore be taken to assess for how long the spare funds are likely to be available
and how likely it is that they will be needed unexpectedly.
l Buying marketable investments. These would need to be easily sold, so those listed on
the Stock Exchange or a similarly liquid and efficient market would tend to be most
appropriate. Equities may well be viewed as too risky a prospect in this context;
the price could easily fall. It would be possible to use a financial derivative, for
example a put option (see Chapter 9) to cover this risk, but at a cost. Some loan
notes, possibly government ones (gilts) might be appropriate. These tend to be less
risky, though holders are exposed to interest rate risk (see Chapter 8). Again, a
financial derivative could be used to hedge this risk.Dealing charges are likely to be involved with buying and selling marketable
securities of both types, which will tend to mean that such investment will be inap-
propriate where small amounts and/or short investment periods are involved.
As with the treatment of any permanent cash surpluses, decisions here should be
based on which action would lead to the greatest enhancement of shareholders’
wealth.Some practical points in the management of cash and overdrafts
Establish a policy
The business should, with the aid of models and other means, establish a policy for
cash. This policy should be adhered to, except in the most unusual circumstances,
until such time as it is formally reviewed.