Cash Management

Cash Management
Learning objectives

Cash Management

Motives for holding cash

Cash Budget Different types of Float

Managing collection and disbursement of cash.

Cash conversion cycle Baumol & Miller-orr Model

Cash Management

The managing of cash flows is an extremely important task for a financial managers. Part of the task is determining how much cash a firm should have on hand at any time to ensure normal business operations continue uninterrupted. So, Cash flow management is the process of monitoring, analyzing, and adjusting the organizations cash
Ways to Manage Cash Firms can manage cash in virtually all areas of operations that involve the use of cash. The goal is to receive cash as soon as possible while at the same time waiting to pay out cash as long as possible.
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Cash inflows and Outflows

Ideally, during the business cycle, most businesses will have more money flowing in than flowing out. This will allow the firm to build up cash balances with which to plug cash flow gaps, seek expansion and reassure lenders and investors about the health of the business. It is important to know that income and expenditure cash flows rarely occur together, with inflows often lagging behind. Firms aim must be to speed up the inflows and slow down the outflows. Cash inflows occur from following activities Payment for goods or services from your customers. Receipt of a bank loan. Interest on savings and investments. Shareholder investments. Increased bank overdrafts or loans.
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Cash inflows and Outflows

Cash outflows occur from following activities

Purchase of stock, raw materials or tools. Wages, rents and daily operating expenses. Purchase of fixed assets - PCs, machinery, office furniture, etc. Loan repayments. Dividend payments. Income tax, corporation tax, VAT and other taxes. Reduced overdraft facilities. Many of your regular cash outflows, such as salaries, loan repayments and tax, have to be made on fixed dates. You must always be in a position to meet these payments in order to avoid large fines or a disgruntled workforce.
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Motives behind holding Cash

Why Firms Hold Cash?

The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity.
Transaction motive

Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have. These are basically to meet payments, such as purchases, wages, taxes, dividends, arising in the ordinary course of business. 6

Motives behind holding Cash

Precautionary motive Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash is held on a precautionary basis. It acts as a safety cushion or buffer to meet unexpected cash needs. The more predictable the inflows and outflows of cash for a firm , the less cash that needs to be held for precautionary needs. Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash balance.

Firms must hedge against the possibility of unexpected needs:

Options for short term bank deposit Hold interest bearing Short term investments. (short term maturity)

Trade Offs:
Interest revenue from the above two options. Transaction costs involved in purchasing and selling such near cash assets.
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Motives behind holding Cash

Speculative motive
Economist Keynes described this reason for holding cash as creating the ability for a firm to take advantage of special opportunities that if acted upon quickly will favor the firm. An example of this would be purchasing extra inventory at a discount that is greater than the carrying costs of holding the inventory. If the firm experience seasonality in sales, then there will be times during the year when such firm will have excess cash, that will be needed later in the year.

Investment Strategy:
Buy back existing bond & stocks when there is excess cash Investment in fixed assets

Participate in Mergers & Acquisitions

Issue bond when needed Short term investments.
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Cash Flow Management Here are a few guidelines to help manage cash flow more effectively: Collect money from debtors (A/R) as quickly as possible. Centralize payments system for different functional areas such as accounts payable and payroll. Develop close partnerships with customers and suppliers to negotiate mutually beneficial payment policies. Develop banking relationships by choosing banks that can offer customized cash management services. You will get advice from banking experts and save on bank charges.

Cash Flow Management Develop cash flow forecasting techniques and models that are linked to budgets and strategic plans. Conduct regular reviews of the cash situation to ensure that the cash balances are approximately the same as in the budget,and analyze any significant variations from budget. Ensure appropriate use of current technology: for example, telephone and internet banking as these are quicker and cheaper. Ensure that investing, borrowing, payment and other financial transactions are properly authorized so as to avoid any improper use of the organization's cash.

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Cash Budget

Cash Budget: A schedule showing cash receipts, cash

disbursements, and cash balances for a firm over a specific time period. Perhaps the most critical ingredient to proper cash management is the ability to estimate the cash flows of the firm so the firm can make plans to borrow when cash is deficient or to invest when cash is in excess of what is needed. So, without the doubt financial managers must rely on the most important tool for managing cash and that is cash budget (forecast). The cash budget helps management plan investment and borrowing strategies, and it also is used to provide feedback and control to improve the efficiency of cash management in the future. The firm estimates its general needs for cash as part of its overall budgeting, or forecasting, process. First, the firm forecasts its operating activities such as expenses and revenues for the period in question. Then, the financing and investment activities necessary to attain the level of operations must be forecasted. Such forecasts entail the construction of pro forma financial statements.

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Cash Budget

The information provided from the pro forma balance sheet and income statement is combined with projections about the delay in collecting accounts receivables, the delay in paying suppliers and employees, tax payment dates, dividend and interest payment dates, and so on. All of this information is summarized in the cash budget, which shows the firms projected cash inflows and outflows, financing over some specified period. Generally, firms use a monthly cash budget forecasted over the next year plus more detailed daily or weekly cash budget for the coming month. The monthly cash budgets are used for planning purposes and the daily or weekly budgets are used for actual cash control.
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Float and its types

Float
Float is defined as the difference between the firms/individuals book balance (book cash or ledger cash) and the balance on the banks record (bank cash or collected bank cash) of an account. In other words float can be defined as Funds that have been sent by the payer but are not yet usable funds to the payee". So, Float represents the net effect of cheques in the process of collections.
Float = Firms bank cash Firms book cash A positive float occurs when the firms bank cash is greater than its book cash. A negative float occurs when the firms book cash is greater than its bank cash.

Cheques written by the firm generate disbursement float, causing an immediate decrease in book cash but no immediate change in bank cash. Cheques received by the firm represent collection float, which increase book cash immediately but does not immediately change bank cash. So, the firm is helped by disbursement float and hurt by collection float. 13 The difference of disbursement float and collection float is net float.

Float and its types

For example, assume that you go to the bank and open a checking account with

$500. You receive no interest on the $500 and pay no fee to have the account. Now assume that you receive your electricity bill in the mail and that it is for $100. You write a cheque for $100 and mail it to the utility company. At the time you write the $100 cheque you also record the payment in your bank register. Your bank register reflects the book value of the checking account. The cheque will literally be "in the mail" for a day or two before it is received by the utility company and may take another few more days before the company cashes it.

This float can be managed. If you know that the bank will not learn about your
cheque for five days, you could take the $100 and invest it elsewhere for the five days and then place it back into your checking account "just in time" to cover the $100 check

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Float and its types

Time T=O (Make Deposit)

Book Bank Balance Balance $500 $500

T=1 (Write $100 cheque) $400 T=2 (Bank receives cheque) $400

$500 $400

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Float and its types

Float is calculated by subtracting the book balance from the bank balance.
Float at Time 0: $500 - $500 = $0 Float at Time 1: $500 - $400 = $100 Float at Time 2: $400 - $400 = $0

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Float and its types

Policy For Cash Being Held (float example)

Here a firm already is holding the cash so the goal is to maximize the benefits from holding it and wait to pay out the cash being held until the last possible moment. Extending the previous example. Assume that rather than investing $500 in a checking account that does not pay any interest, you invest that $500 in liquid investments.

Further assume that the bank believes you to be a low credit risk and allows you to maintain a balance of $0 in your checking account.
This allows you to write a $100 cheque to the electric company and then transfer funds from your investment to the checking account in a "just in time" fashion. By employing this JIT system you are able to draw interest on the entire $500 up until you need the $100 to pay the utility company. Firms often have policies similar to this one to allow them to maximize idle cash.

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Float and its types

Example: A cheque of $1000 is mailed from a customer on Monday,

September 1. Because of mail, processing and clearing delays, it is not credited as available cash in the firms bank until the following Monday, seven days later. The float for this cheque is:

Float = $1000 X 7 days = $7000

Another cheque for $7000 is mailed on September 1. it is available on the next day. The float for this cheque is: Float = $7000 X 1day = $7000 The measurement of float depends on the time lag and the amount involved. The cost of float is an opportunity cost, because the cash is unavailable for use during the time cheques are tied up in the collection process.
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Cash Management System

Collections
Disbursements

Marketable securities investment Control through information reporting

= Funds Flow = Information Flow
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Speeding Up Cash Receipts

Collections

Expedite preparing and mailing the invoice Accelerate the mailing of payments from customers Reduce the time during which payments received by the firm remain uncollected

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Collection Float

Mail Float

Processing Float

Availability Float

Deposit Float Collection Float: total time between the mailing of the check by the customer and the availability of cash to the receiving firm.
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Mail Float

Customer mails check

Firm receives check

Mail Float: time the check is in the mail. Cheques are trapped in the postal system. It is the part of collection float.
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Processing Float

Firm receives check

Firm deposits check

Processing Float: time it takes a company to process the check internally. It is also a part Of collection float
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Availability Float

Firm deposits check

Firms bank account credited

Availability Float: time required in clearing the check through the banking system. It is also A part of collection float.
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Deposit Float

Processing Float

Availability Float

Deposit Float: time during which the check received by the firm remains uncollected funds. So, the deposit float has two aspects. The first aspect is the processing float and second being 25 The availability float.

Earlier Billing
Accelerate preparation and mailing of invoices

computerized billing invoices included with shipment invoices are faxed advance payment requests preauthorized debits

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Preauthorized Payments
Preauthorized debit The transfer of funds from a payors bank account on a specified date to the payees bank account; the transfer is initiated by the payee with the payors advance authorization.

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Lockbox System
Lockbox A post office box maintained by a firms bank that is used as a receiving point for customer payments.

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Lockbox Process

Customers are instructed to mail their payments to the lockbox location. Bank picks up payments several times daily from the lockbox. Bank deposits payments in the customers account and provides a deposit slip with a list of payments. Often the checks are first scanned and converted into digital images. These images can then be transmitted to the company or supplied on a CD-ROM. Company also receives the list and any additional mailed items.
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Lockbox System
Advantage
Receive payments sooner which reduces processing float. Disadvantage
Cost of creating and maintaining a lockbox system. Generally, not advantageous for small amount payments.

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Concentration Banking
Moving cash balances to a central location:

Improves control over inflows and outflows of corporate cash. Reduces idle cash balances to a minimum. Allows for more effective investments by pooling excess cash balances.

Compensating Balance
Minimum account balance maintained by a firm to compensate a bank for services provided, credit lines, or loans.
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Concentration Services for Transferring Funds

Automated Clearing House (ACH) Electronic transfer
An electronic version of check.

(1) Electronic check image . (2) Cost is not significant . Wire Transfer : A generic term for electronic funds transfer using a two-way communications system,

Funds are available upon receipt of the wire transfer. Much more expensive.
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S-l-o-w-i-n-g D-o-w-n Cash Payouts

Control of Disbursements

Payroll and Dividend Disbursements Zero Balance Account (ZBA)

Remote and Controlled Disbursing

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Methods of Managing Disbursements

Payroll and Dividend Disbursements
The firm attempts to determine when payroll and dividend checks will be presented for collection.

Many times a separate account is set up to handle each of these types of disbursements. A distribution scheduled is projected based on past experiences. Funds are deposited based on expected needs. Minimizes excessive cash balances.
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Percentage of Payroll Checks Collected

100% Percent of Payroll Collected
75% The firm may plan on payroll checks being presented in a similar pattern every pay period.

50%
25% 0% F M (Payday) T

M and after
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Methods of Managing Disbursements

Zero Balance Account (ZBA):
A corporate current account in which a zero balance is maintained. The account requires a master (parent) account from which funds are drawn to cover negative balances or to which excess balances are sent.

Eliminates the need to accurately estimate each disbursement account. Only need to forecast overall cash needs.
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Remote and Controlled Disbursing

Controlled Disbursement -- A system in which the firm directs checks to be drawn on a bank (or branch bank) that is able to give early or mid-morning notification of the total dollar amount of checks that will be presented against its account that day.
Late check presentments are minimal, which allows more accurate predicting of disbursements on a day-to-day basis.
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Cash Conversion Cycle

The length of time from the payment for the purchase of raw materials to manufacture a product until the collection of accounts receivable associated with the sale of the product.

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Cash Conversion Cycle

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Inventory Conversion Period

The inventory conversion period is the length of time from the purchase of inventory to the time the sales are made on credit.

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Receivables Collection Period

The receivables collection period is the average number of days it takes to collect on accounts receivable. Equal to days sales outstanding (DSO)

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Payables Deferral Period

The payables deferral period is the average length of time between the purchase of materials and labor and the payment of cash for the same.

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Operating Cycle
The time from the beginning of the production process to the collection of cash from the sale of the finished product. Operating Cycle = Inventory Conversion Period + Receivables Collection Period

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Determining the Target Cash Balance

Baumol

Model

Deterministic

model. Future cash requirements and disbursements are known with perfect certainty
Miller-Orr

Model

Stochastic

model. Daily cash flows vary according to a normal probability distribution with known variance

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Costs of Holding Cash

Costs in dollars of holding cash

Trading costs increase when the firm must sell securities to meet cash needs.
Total cost of holding cash

Opportunity Costs The investment income foregone when holding cash.

Trading costs C* Size of cash balance
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The Baumol Model F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed K = The opportunity cost of holding cash: this is the interest rate. If we start with $C, C = Size of each deposit spend at a constant rate
C
C 2

each period and replace our cash with $C when we run out of cash, our average cash balance will be C .

Time

2 The opportunity cost of holding C is C K 2 2

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The Baumol Model F = The fixed cost of selling securities to raise cash
T = The total amount of new cash needed K = The opportunity cost of holding cash: this is the interest rate. C = Size of each deposit

C
C 2

As we transfer $C each period we incur a trading cost of F each period. If we need T in total over the planning period we will pay $F, T C times. The trading cost is T F C 1 2 3 Time
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The Baumol Model C

T Total cost K F 2 C

C Opportunity Costs K 2

Trading costs T F

C* Size of cash balance The optimal cash balance is found where the opportunity costs equal the trading costs 2T * C F K

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The Baumol Model

The optimal cash balance is found where the opportunity costs equal the trading costs Opportunity Costs = Trading Costs

C T K F 2 C
Multiply both sides by C

C2 K T F 2
2TF C K
*

T F C 2 K
2

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Limitations of Baumol model

1.

2.

3.

The model assumes the firm has constant disbursement rate. In practice disbursements can be only partially managed, because due dates differ and costs can not be predicted with certainty. The model assumes there are no cash receipts during the projected period. In fact, most firms experience both cash inflows and outflows on a daily basis. No safety stock is allowed for. Firms will probably want to hold a safety stock of cash designed to reduce the possibility of cash shortage or cash-out. However, to the extent that firms can sell marketable securities or borrow in a short notice, the need for safety stock is minimal.
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The Miller-Orr Model The firm allows its cash balance to wander randomly between upper and lower control limits.
$
When the cash balance reaches the upper control limit H cash is invested elsewhere to get us to the target cash balance Z.

When the cash balance reaches the lower control limit, L, investments are sold to raise cash Z to get us up to the target cash balance. L

Time

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The Miller-Orr Model

3F 2 Z* 3 L 4K

H 3Z 2 L
*

where s2 = is the variance of net daily cash flows. = is the standard deviation of the net cash flows F = Fixed cost of converting securities into cash K = annual opportunity cost of holding cash LCL (L) = Lower control limit UCL (H) = Upper control limit Z = The amount of securities converted into cash when cash balance hits the LCL. The average cash balance in the Miller-Orr model is

Given L, which is set by the firm, the Miller-Orr model solves for Z and H.

4Z * L Average cash balance 3

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Implications of the Miller-Orr Model

To use the Miller-Orr model, the manager must do four things: 1. Set the lower control limit for the cash balance.
2. 3. 4.

Estimate the standard deviation of daily cash flows. Determine the interest rate. Estimate the trading costs of buying and selling securities.

The model clarifies the issues of cash management:

The best return point, Z, is positively related to trading costs, F, and negatively related to the interest rate K. Z and the average cash balance are positively related to the variability of cash flows.
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End of the Chapter

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