Accounting Business Reporting for Decision Making

CHAPTER 13 Financing the business 533

and 67 per cent respectively). Qantas Group has negative net working capital; however, close exam-

ination of the components of current liabilities for the Qantas Group reveals a large amount of revenue

received in advance. In fact, if we deduct the amount of revenue received in advance from total current

liabilities the recalculated net working capital becomes positive — $1.17 billion (130 per cent). These

examples reflect the decisions that have been made by each entity’s management regarding the levels

of cash, accounts receivable and inventory held. They show that a wide range of values is considered

appropriate for each entity’s particular cash-flow patterns and environment.

VALUE TO BUSINESS

•   Net working capital is current assets minus current liabilities.

•   In managing the level of net working capital, the entity is concerned with three aspects:

• maintaining liquidity


• the need to earn the required rate of return on assets


• the cost and risk of short-term funding.
  • Liquidity is a measure of the ease of conversion of an asset into cash.
  • Entities need liquidity to pay their bills on time and maintain business confidence.
  • If working capital is allowed to increase to an inappropriately high level, it can reduce the average
  rate of return on equity.
  • The short-term loans component of current liabilities has a cost, normally comprising both fees and
  interest, and the financial manager must be convinced that the benefits to the entity exceed the
  cost.
  • To decide an appropriate level of net working capital, many entities use the hedging principle.
  • The hedging principle is based on the idea of matching the maturity of the source of funding with its
  use.
  • Entities categorise funding as permanent, temporary and spontaneous, and use a matching principle
  to decide appropriate levels.
  • The principles for using the permanent, temporary and spontaneous classifications to advantage are:


• permanent assets should be financed with permanent and spontaneous sources of funding


• temporary assets should be financed with temporary sources of funding.

13.2 Managing cash

LEARNING OBJECTIVE 13.2 Outline the issues underlying the management of cash.

Entities manage cash with regard to the following issues:

• the need to have sufficient cash


• the timing of cash flows


• the cost of cash


• the cost of not having enough cash.

The need to have sufficient cash

An entity must always have sufficient cash on hand to meet its financial obligations. This means having

enough cash to pay wages and taxes, and bills as they come due; and sufficient cash or near-cash

(deposits, commercial bills or pre-approved credit) to meet expected bills in the immediate future. The

contrasting position is described as being insolvent. An insolvent entity is unable to pay its bills or meet

its financial obligations on time.

Managers face a trade-off between risk and return when contemplating how much cash to hold. Cost

may be minimised by holding as little cash as possible, but risk is increased. A manager overseeing the

cash position of an entity can cut cash holdings so that they just cover contemplated expenses, but what

would happen if an unexpected bill was received? Liquid funds would have to be arranged quickly, and