Cash Management Techniques

Cash & Marketable Securities

Cash & Marketable Securities Balances

• Like other financial decisions, the goal of the firm is to

maintain the level of cash and marketable securities that

maximizes shareholder and firm value.

• Balances that are too high will diminish profitability --

and balances that are too low will accentuate risk.

• Although the more sophisticated mathematical

estimation models are beyond our scope, the overriding

objective is to balance risk against return.

Estimating Desirable Cash Balances

Cash & Marketable Securities Balances

• In addition to earning a return on temporarily idle funds,

marketable securities serve as a safety stock of cash

that can be deployed to satisfy unexpected demands for

funds.

• For example, if a company wishes to maintain $70,000

of liquid funds and a transactions balance of $50,000 --

$20,000 would be held as marketable securities.

• In addition, a firm could use a line of credit in lieu of

marketable securities -- or a combination of both.

The Level of Marketable Securities Investment

raw materials purchases(payable generated)

Payment received(receivable exonerated)

inventoryprocessing

finished goodsinventory

sale of goods(receivable generated)

payment for purchases(payable exonerated)

The Efficient Management of CashRecall the Operating Cycle from the Last Chapter...

The Efficient Management of Cash

The Operating Cycle (OC) is the time between ordering materials and collecting cash from

receivables.

The Cash Conversion Cycle (CCC) is the time between when a firm pays it’s suppliers (payables) for inventory and collecting cash from the sale of

the finished product.

Both the OC and CCC may be computed mathematically as shown below.

Operating Cycle (OC) = Average Age of Inventory (AAI) +

Average Collection Period (ACP)

Cash Conversion Cycle (CCC) = Operating Cycle (OC) -

Average Payment Period (APP)


Managing the Cash Conversion Cycle

• Most companies) has a positive CCC.

• As a result, the company will have to finance this period using some combination of short-term financing such as a line of credit or revolving credit agreement.

• By looking at the model, we can also see that the firm could improve its financial condition by (1) shortening the AAI, (2) Shortening the ACP, (3) lengthening the APP, or (4) some combination of the above.


Cash Management Techniques

• Collection float is the delay between the time when a

payer deducts a payment from its checking account

ledger and the time when the payee actually receives

the funds in spendable form.

• Disbursement float is the delay between the time when a

payer deducts a payment from its checking account

ledger and the time when the funds are actually

withdrawn from the account.

• Both the collection and disbursement float have three

separate components.

Float


• Mail float is the delay between the time when a payer

places payment in the mail and the time when it is

received by the payee.

• Processing float is the delay between the receipt of a

check by the payee and the deposit of it in the firm’s

account.

• Clearing float is the delay between the deposit of a

check by the payee and the actual availability of the

funds which results from the time required for a check to

clear the banking system.

Float

Cash Management TechniquesFloat


• Concentration banking is a collection procedure in which

payments are made to regionally dispersed collection

centers.

• Checks are collected at these centers several times a

day and deposited in local banks for quick clearing.

• It reduces the collection float by shortening both the mail

and clearing float components.

Speeding Collections

Concentration Banking


• A lockbox system is a collection procedure in which

payers send their payments to a nearby post office box

that is emptied by the firm’s bank several times a day.

• It is different from and superior to concentration banking

in that the firm’s bank actually services the lockbox

which reduces the processing float.

• A lockbox system reduces the collection float by

shortening the processing float as well as the mail and

clearing float.


Lockboxes


• A direct send is a collection procedure in which the payee presents checks for payment directly to the banks on which they are drawn, thus reducing the clearing float.

• Pre-authorized checks (PAC) is a check written against a customer’s account for a previously agreed upon amount avoiding the need for the customer’s signature.

• Depository transfer checks (DTC) are unsigned checks drawn on one of the firm’s accounts and deposited at a concentration bank to speed up transfers.


Direct Sends and Other Techniques


• Wire transfers is a telecommunications bookkeeping device that removes funds from the payer’s bank and deposits them into the payees bank -- thereby reducing collections float.

• Automated clearinghouse (ACH) debits are pre-authorized electronic withdrawals from the payer’s account that are transferred to the payee’s account via a settlement among banks by the automated clearinghouse.

• ACHs clear in one day, thereby reducing mail, processing, and clearing float.


Direct Sends and Other Techniques


• Controlled disbursing involves the strategic use of mailing points and bank accounts to lengthen mail float an clearing float.

• Playing the float is a method of consciously anticipating the resulting float or delay associated with the payment process and using it to keep funds in an account as long as possible.

• Staggered funding is a method of playing the float by depositing a certain portion of a payroll into an account on several successive days following the issuance of checks.

Slowing Disbursements


• With an overdraft system, if the firm’s checking account

balance is insufficient to cover all checks presented, the

bank will automatically lend money to cover the account.

• A zero-balance account is an account in which a zero

balance is maintained and the firm is required to deposit

funds to cover checks drawn on the account only as

they are presented for payment.

Slowing Disbursements

The Role of Banking Relationships

• Maintaining strong banking relationships is one of the

most important elements of an effective cash

management system.

• In recent years, banks have become a source for a wide

variety of cash management services which are

designed to help financial managers maximize day-to-

day cash availability and facilitate short-term investing.

Marketable Securities

• Marketable securities are short-term, interest bearing

money market instruments that can easily be converted

into cash

• Securities that are most commonly-held as part of a

marketable securities portfolio can be segmented into

two groups -- government issues and non-government

issues.

Marketable Securities

• To qualify as a marketable securities investment, the

instruments must have a ready market -- which means it

must be both “broad” and “deep.”

• The breadth of a market is determined by the number of

participants (buyers).

• The depth of a market is determined by its ability to

absorb the purchase or sale of a large dollar amount of

a particular security.

• A ready market must have both of these characteristics.

Characteristics

Characteristics of Short-Term Securities

• Maturity – firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates

• Default risk – avoid investing in marketable securities with significant default risk

• Marketability – ease of converting to cash• Taxability – consider different tax

characteristics when making a decision

Figure

Cash Conversion Models

• Cash conversion models are used to help determine the

optimal quantity of marketable securities to convert into

cash when needed (and vice versa).

• The cash conversion quantity depends on a number of

factors, including the fixed cost of transferring funds

between cash and marketable securities, the rate of

interest, and the firms demand for cash.

• The objective of these models is to balance the costs

and benefits of holding cash versus investing in

marketable securities.

Maintaining Cash Balance

• Assuming that liquidity is maintained in the form of cash, bank balances and a portfolio of marketable securities.

• It is necessary for a finance manager to know what should be the optimum cash and bank balances he must maintain and for that purposes how often and in what quantity securities should be purchased and sold

• The following models addresses these issues

The models• The models are divided in two parts

Certainty model- Baumol*

Uncertainty model-Miller and Orr*

*Baumol, W.J., “The Transactions Demand for Cash: An Inventory Theoretic Approach”, Quarterly Journal of Economics, November 1952, pp. 545-556

*Miller, M. H. and Daniel, Orr, “A Model of the Demand for Money by Firms”. Quarterly Journal of Economics, August 1966,pp. 413-435


• The Baumol model is a simple approach that provides

for cost-efficient cash balances by determining the

optimal cash conversion quantity.

• The firm manages its cash inventory by calculating two

costs:

– the cost of converting marketable securities into

cash and vice versa, and

– the cost of holding cash rather than marketable

securities.

Baumol Model

Baumol ModelTotal Cost = b(T/C)+i(C/2)

iC2= 2bT

C2= 2bT i

C = 2bT i

Where T/C= cash turnover ratio or the no. of transactions effected during a period, when this is multiplied by b, the fixed charge per unit of transaction we obtain total transaction cost during the period.

C/2 represents the average cash balance which when multiplied by i gives the opportunity cost of foregone investment opportunity.

Our purpose is to find out C that minimizes the total cost


• The Baumol model may be written as shown in Equation

below:

Baumol Model


• The Baumol model may be described graphically as

shown in Figure below.

Baumol Model

Cash Conversion ModelsBaumol Model

A firm estimates that it is required to make cash disbursements of Rs 567 lakh in a year which is spread over uniformly at Rs 47.25 lakh per month. The firm invests only in treasury bills for cash management purposes. The present yield is 8% p.a. It costs the firm Rs. 900 for every transaction in Treasury Bills. Calculate

C= 2x900x567,00,000 0.08 = 11,29,491or say 11.30 lakh

Cash Turnover Ratio

• 567,00,000/11,29,491=50.20 or 50 times a year

• 47,25,000/11,29,491=4.18 or 4 times a month

Short-comings of Baumol’s model• Specification of cost- Rate of interest on

securities particularly on TBs are fairly known, fixed cost associated with security transaction is difficult to estimate as majority parts are overheads e.g brokerage, storage cost etc.

• Assumption of steady usage of cash during the period under consideration

• Under high uncertainty in the cash flows this model does not work

• Under moderate degree of uncertainty a cushion viz safety stock may be factored

Uncertainty Model Miller-Orr• When uncertainty of cash flows is very high resulting in

random fluctuations in cash balances, EOQ-Cash model may not work and one has to find a solution in stochastic models.

• Miller and Orr set up two control limits of cash holding: upper limit and lower limit

• When cash balances reaches the upper limit, a transfer of cash to market securities takes place by purchasing securities and when it reaches a lower limit, a transfer from market securities to cash takes place by selling securities

• When cash balance stays within these bounds, no transaction takes place.


• The Miller-Orr model is generally more realistic than the

Baumol model.

• It provides for cost-efficient cash balances by determining an

upper limit (maximum amount) and a return point (target cash

balance).

Uncertainty Model Miller-Orr

Miller-OrrModel

Cash Conversion ModelsMiller-Orr Model

Example

It costs JanCo $30 to convert marketable securities to cash and vice versa; the firm’s marketable securities

portfolio earns an 8% annual return, which is 0.0222 daily (8%/360 days). The variance of JanCo’s daily net cash

flow is estimated to be $27,000. Substituting into Equation 16.5 yields the return point:

Miller and Orr Model A company projects the daily net cash flows for the

next seven days as follows:

Day 1 2 3 4 5 6 7Cash Flow +24 +13 -16 -12 +36 +4 -28Forecast

The policy of the company is to maintain a minimum cash balance of Rs. 10,000 at all the times. Fixed cost for every security transaction is Rs. 1,600 and return on marketable securities is 10% p.a. The company desires to know the return point (Z) and the upper limit of cash holding that would trigger a purchase order for securities.

SolutionCalculation of the variance of cash flows forecast

Daily CFF (Xi) (X) (Xi- X) (Xi- X)2 Variance (S2)

24 ∑x/n=21/7 21 441 ∑ (Xi- X)2/n 13 =Rs.3 10 100 = 3178/7

-16 -19 361 = Rs. 454 -12 -15 225 36 33 1089 4 1 1 -28 -31 961 21 0 3178

• Return Point (Z) =10,000+3√3x1600x454,00,000

4x(0.10)/365 = Rs. 10,000+58,368 = RS. 68,368 • Upper Limit = Rs. 10,000+3x58,368 = Rs. 1,85,104

Interpretation These two findings signify that the finance

manager will allow the daily cash balance to fluctuate till it reaches the upper limit of Rs.1,85,104. When the balance becomes greater than this figure, he will purchase sufficient worth of securities to reduce the cash balance to the return point of Rs.68,368. On the lower side, when the cash balance drops to the minimum balance of Rs.10,000 he will sell the adequate amount of securities to raise the cash balance to Rs.68,368.

Cash Management Techniques

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