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Ch. 16: Liquid AssetCh. 16: Liquid Asset

ManagementManagement

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Liquid Asset Management

CASHCASH-- motives for holding cash:motives for holding cash:

TransactionsTransactions: to meet cash needs: to meet cash needsthat arise from doing business.that arise from doing business.

PrecautionaryPrecautionary: having cash on hand: having cash on handfor unexpected needs.for unexpected needs.

SpeculativeSpeculative: to take advantage of: to take advantage ofpotential profitpotential profit--making situations.making situations.

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Cash Management

ObjectivesObjectives::

have enough cash on hand to meethave enough cash on hand to meetdisbursal needs.disbursal needs.

Minimize investment in idle cashMinimize investment in idle cashbalances.balances.

Tradeoff: cash decreases risk ofTradeoff: cash decreases risk ofinsolvency, but earns no returnsinsolvency, but earns no returns

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Cash Management

Managing Cash InflowManaging Cash Inflow

Reducing Float can speed up cash receipts.Reducing Float can speed up cash receipts.

Mail FloatMail Float: length of time from the: length of time from themoment a customer mails a check until themoment a customer mails a check until the

firm begins to process it.firm begins to process it.

Processing FloatProcessing Float: the time required by a: the time required by a

firm to process a check before it can befirm to process a check before it can be

deposited in a bank.deposited in a bank.

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Cash Management

Managing Cash InflowManaging Cash Inflow

Reducing Float can speed up cash receipts.Reducing Float can speed up cash receipts.

Transit floatTransit float: time required for a check to: time required for a check toclear through the banking system andclear through the banking system and

become usable funds.become usable funds.

Disbursing floatDisbursing float: occurs because funds are: occurs because funds are

available in a firms bank account until itsavailable in a firms bank account until its

payment check has cleared through thepayment check has cleared through the

banking system.banking system.

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Cash Management

Managing Cash InflowManaging Cash Inflow

Lockbox SystemLockbox System

Instead of mailing checks to the firm,Instead of mailing checks to the firm,customers mail checks to a nearby P.O.customers mail checks to a nearby P.O.

Box.Box.

A commercial bank collects and depositsA commercial bank collects and depositsthe checks.the checks.

This reducesThis reduces mail float, processing floatmail float, processing float

andand transit float.transit float.

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Cash Management

Lockbox System benefits:Lockbox System benefits:

Increased working cashIncreased working cash -- reducesreduces

time required to convert receivables totime required to convert receivables tocash.cash.

Elimination of clerical functionsElimination of clerical functions -- bankbank

handles receiving, endorsing, totalinghandles receiving, endorsing, totaling

and depositing.and depositing.

Early knowledge of dishonored checksEarly knowledge of dishonored checks --

firm learns of customers bad checksfirm learns of customers bad checks

faster.faster.

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Cash Management

Managing Cash InflowManaging Cash Inflow

Preauthorized Checks (PACs)Preauthorized Checks (PACs)

Arrangement that allows firms to createArrangement that allows firms to createchecks to collect payments directly fromchecks to collect payments directly from

customer accounts.customer accounts.

This reducesThis reduces mail float and processingmail float and processing

float.float.

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Cash Management

PAC System benefits:PAC System benefits:

Highly predictable cash flows.Highly predictable cash flows.

Reduced expensesReduced expenses -- eliminates billingeliminates billingand postage costs; reduces clericaland postage costs; reduces clerical

processing costs.processing costs.

Customer preferenceCustomer preference -- eliminateseliminates

regular billing for customers.regular billing for customers.

Increased working cashIncreased working cash -- dramaticallydramatically

reduces mail float and processing float.reduces mail float and processing float.

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Cash Management

Managing Cash InflowManaging Cash Inflow

Depository Transfer ChecksDepository Transfer Checks

(DTCs)(DTCs)Moves cash from local banks toMoves cash from local banks to

concentration bank accounts.concentration bank accounts.

Firms avoid having idle cash inFirms avoid having idle cash inmultiple banks in different regions ofmultiple banks in different regions of

the country.the country.

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Cash Management

DTC System benefits:DTC System benefits:

Lower levels of excess cashLower levels of excess cash --

Reduced expensesReduced expenses -- eliminates billingeliminates billingand postage costs; reduces clericaland postage costs; reduces clerical

processing costs.processing costs.

Customer preferenceCustomer preference -- eliminateseliminatesregular billing for customers.regular billing for customers.

Increased working cashIncreased working cash -- dramaticallydramatically

reduces mail float and processing float.reduces mail float and processing float.

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Cash Management

Managing Cash InflowManaging Cash Inflow

Wire TransfersWire Transfers

Moves cash quickly between banks.Moves cash quickly between banks.

EliminatesEliminates transit floattransit float..

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Cash Management

Managing Cash OutflowManaging Cash Outflow

Zero Balance Accounts (ZBAs)Zero Balance Accounts (ZBAs)

Different divisions of a firm may write checksDifferent divisions of a firm may write checksfrom their own ZBA.from their own ZBA.

Division accounts then have negativeDivision accounts then have negative

balances.balances.Cash is transferred daily from the firmsCash is transferred daily from the firms

master account to restore the zero balance.master account to restore the zero balance.

Allows more control over cash outflows.Allows more control over cash outflows.

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Cash Management

Managing Cash OutflowManaging Cash Outflow

PayablePayable--Through Drafts (PTDs)Through Drafts (PTDs)

Allows the firm to examine checks writtenAllows the firm to examine checks writtenby the firms regional units.by the firms regional units.

Checks are passed on to the firm, whichChecks are passed on to the firm, which

can stop payment if necessary.can stop payment if necessary.

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Cash Management

Managing Cash OutflowManaging Cash Outflow

Remote DisbursingRemote Disbursing

Firm writes checks on a bank in a distantFirm writes checks on a bank in a distanttown.town.

This extends disbursing float.This extends disbursing float.

(Discouraged by the Federal Reserve(Discouraged by the Federal ReserveSystem)System)

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Marketable Securities

ConsiderationsConsiderations

Financial RiskFinancial Risk-- uncertainty ofuncertainty of

expected returns due to changes inexpected returns due to changes in

issuers ability to pay.issuers ability to pay.

Interest rate riskInterest rate risk-- uncertainty ofuncertainty of

expected returns due to changes inexpected returns due to changes in

interest rates.interest rates.

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Marketable Securities

ConsiderationsConsiderations

LiquidityLiquidity -- ability to transformability to transform

securities into cash.securities into cash.

TaxabilityTaxability -- Taxability of interestTaxability of interest

income and capital gains.income and capital gains.

YieldYield -- Influenced by the previous 4Influenced by the previous 4

considerations.considerations.

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Marketable Securities

TypesTypes

Treasury BillsTreasury Bills -- short term securitiesshort term securities

issued by the U.S. government.issued by the U.S. government.

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Marketable Securities

TypesTypes

Federal Agency SecuritiesFederal Agency Securities -- DebtDebt

issued by agencies, including:issued by agencies, including:Federal National Mortgage AssociationFederal National Mortgage Association

(Fannie Mae)(Fannie Mae)

Federal Home Loan BanksFederal Home Loan BanksFederal Land BanksFederal Land Banks

Federal Intermediate Credit BanksFederal Intermediate Credit Banks

Banks for the CooperativesBanks for the Cooperatives

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Marketable Securities

TypesTypes

Bankers AcceptancesBankers Acceptances -- short termshort term

securities used in internationalsecurities used in international

trade. Sold on discount basis.trade. Sold on discount basis.

Negotiable CDsNegotiable CDs -- shortshort--termterm

securities issued by banks, withsecurities issued by banks, with

typical deposits of $100,000,typical deposits of $100,000,

$500,000 and $1 million.$500,000 and $1 million.

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Marketable Securities

TypesTypes

Commercial PaperCommercial Paper -- shortshort--termterm

unsecured IOUs sold by largeunsecured IOUs sold by largereputable firms to raise cash.reputable firms to raise cash.

Repurchase AgreementsRepurchase Agreements -- anan

investor acquires shortinvestor acquires short--termtermsecurities subject to a commitmentsecurities subject to a commitment

from a bank to repurchase thefrom a bank to repurchase the

securities on a specific date.securities on a specific date.

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Marketable Securities

TypesTypes

Money Market Mutual FundsMoney Market Mutual Funds -- aa

pool of money market securities,pool of money market securities,divided into shares,divided into shares,

which are sold towhich are sold to

investors.investors.

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AccountsR

eceivable Management

Size of Investment in AccountsSize of Investment in AccountsReceivableReceivable

Percent of Credit Sales to Total SalesPercent of Credit Sales to Total Sales

Level of SalesLevel of Sales

Terms of SaleTerms of Sale

Quality of CustomerQuality of Customer

Collection EffortsCollection Efforts

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AccountsR

eceivable Management

Terms of SaleTerms of Sale

quoted asquoted as a/b net ca/b net c , which means, which meansdeductdeduct a%a% if paid withinif paid within bb daysdays,,otherwise pay withinotherwise pay within cc daysdays..

example:example: 3/30 net 603/30 net 60, means, meansdeduct 3% if paid within 30 days,deduct 3% if paid within 30 days,otherwise pay the entire amountotherwise pay the entire amountwithin 60 days.within 60 days.

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x

x

Accounts Receivable

Management: opportunity cost

a 360a 360

11 -- a ca c -- bb

opportunity cost of forgoingopportunity cost of forgoing 3/30 net 603/30 net 60::

.03 360.03 36011 -- .03 60.03 60 -- 3030

= 37.11%= 37.11%

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Inventory Management

Too much inventory is expensive andToo much inventory is expensive and

wasteful.wasteful.

Not enough inventory can result inNot enough inventory can result in

lost sales.lost sales.

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Inventory Management

Raw materials inventoryRaw materials inventory -- basic materialsbasic materials

to be used in the firms operations.to be used in the firms operations.

WorkWork--inin--process inventoryprocess inventory -- partiallypartially

finished goods requiring additional workfinished goods requiring additional work

before becoming finished goods.before becoming finished goods.

FinishedFinished--goods inventorygoods inventory -- completedcompletedproducts that are not yet sold.products that are not yet sold.

Stock of cashStock of cash -- inventory of cash to allowinventory of cash to allow

payment of bills.payment of bills.

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Inventory Management

Optimal inventory order sizeOptimal inventory order size: the: theEconomic Order Quantity (EOQ)Economic Order Quantity (EOQ)

model:model:

Estimate of the cost minimizingEstimate of the cost minimizingamount of inventory to orderamount of inventory to order

Order pointOrder point

Average inventoryAverage inventory

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2SO2SO

CC

Economic Order

Quantity Model

Q* =Q* = opt. inventory order size in unitsopt. inventory order size in units

C=

C= cost of carrying 1 unit in inventorycost of carrying 1 unit in inventory

S =S = total demand in units over planningtotal demand in units over planning

periodperiod

O =O = ordering cost per orderordering cost per order

Q* =

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Example: Inventory Management

Q* =Q* = inventory order size in units (Q*= 2000)inventory order size in units (Q*= 2000)

C =C = cost of carrying 1 unit in inventorycost of carrying 1 unit in inventory = 1.25= 1.25

S =S = total demand in units over planningtotal demand in units over planning

period =period = 10,000 units10,000 units

O =O = ordering cost per order =ordering cost per order = $250$250

2SO2SO

CC

Q* =