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Cash: Chapter currency and coins plus demand deposit accounts
Marketable securities: security investments (financial assets) the firm
can quickly convert to cash balances. Also known as near cash or nearcash assets
Why a company holds cash
The cash flow process
Funds can be obtained in the financial markets from the sale of
securities such as bonds, preferred stock, and common stock, or the
firm can enter into nonmarketable-debt contracts with lenders such as
commercial banks.
Whereas the irregular cash inflows are from external sources, the other
main sources of cash arise from internal operations and occur on a
more regular basis.
Apart from the investment of excess cash in near-cash assts, the cash
balance experiences reductions for three key reasons
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On an irregular basis, withdrawals are made to:
1. Pay cash dividends on preferred and common stock shares
2. Meet interest requirements on debt contracts
3. Repay the principal borrowed from creditors
4. Buy the firms own shares in the financial markets for use in
executive compensation plans or as an alternative to paying a
cash dividend
5. Pay tax bills
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The companys capital expenditure program designates that
fixed assets be acquired at various intervals
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Inventories are purchased on a regular basis to ensure a steady
flow of finished goods rolls off the production line.
Motives for Holding Cash
Transaction Motive
Balances held for transaction purposes allow the firm to meet its cash
needs that arise in the ordinary course of doing business.
Precautionary Motive
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It relates to the maintenance of balances used to satisfy possible, but
as yet unknown, needs. The cash flow predictability of the firm has a
material influence on this precautionary motive. In actual practice, it is
met to a large extent by the holding of a portfolio of liquid assets
Speculative Motive
Cash is held for speculative purposes in order to take advantage of
potential profit-making situations. It is the least important component
of a firms preference for liquidity. The transactions and precautionary
motives account for most of the reasons why a company holds cash
balances.
Cash Management Objectives and Decisions
The Risk-Return Trade-Off
Firm must be concerned with insolvency:
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The inability to meet interest payments or to repay debt at
maturity
The financial manager must strike an acceptable balance between
holding too much cash and too little cash.
Objectives
1. Enough cash must be on hand to meet the disbursal needs that
arise in the course of doing business
2. Investment in idle cash balances must be reduced to a minimum.
Decisions
Two conditions would allow the firm to operate for extended periods
with cash balances near or at zero
1. A completely accurate forecast of its net cash flows over the
planning horizon
2. Perfect synchronization of its cash receipts and disbursements
Given that the firm will invest in some cash balances, certain types of
decisions related to the size of those balances dominate the cash
management process. These include decisions that answer the
following questions.
1. What can be done to speed up cash collections and slow down or
better control cash outflows?
2. What should be the composition of the firms marketable-
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securities portfolio?
Collection and Disbursement Procedures
Managing the Cash Inflow-Speeding up Collections
Float: the length of time from when a check is unwritten until the
actual recipient can draw upon the funds
Mail float: time required to receive the check
Processing Float: the time required to process the check by the
company
Transit float: the time required to transfer funds from the customers
account to the firms account.
The lock box arrangement is probably the most widely used tool for
seeding up the collection process and thereby reducing the float.
The Lock Box Arrangement
Sales per day x days of float reduction x assumed yield = gross annual
savings
Managing the Cash Outflow Slowing Down Disbursements
Zero Balance accounts a cash management tool that permits
centralized control over cash outflow while maintaining divisional
disbursing authority. Objectives are to achieve better control over cash
payments; to reduce excess cash balances held in regional banks for
disbursing purposes; and to increase disbursing float.
Payable Through Draft: a legal instrument that has the physical
appearance of an ordinary check but is not drawn on a bank. A
payable-through draft is drawn on and paid by the issuing firm. The
bank serves as a collection point and passes the draft on to the firm.
Evaluating the Costs of Cash Management Services
P = (D)(S)(i)
P = increases in per check processing cost if the new system is
adopted
D = days saved in the collection process (float reduction)
i = the daily, before-tax opportunity cost (rate of return) of carrying
cash
The Composition of a Marketable Securities Portfolio
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General Selection Criteria
Financial Risk: refers to the uncertainty of expected returns from a
security attributable to possible changes in the financial capacity of the
security issuer to make future payments to the security owner
Interest Rate Risk: refers to the uncertainty of expected returns from a
financial instrument attributable to changes in interest the rates.
Liquidity: refers to the ability to transform a security into cash.
Taxability: The tax treatment of the income a firm receives from its
security investments does not affect the ultimate mix of the
marketable-securities portfolio as much as the criteria mentioned
earlier. This is because the interest income from most instruments
suitable for inclusion in the portfolio is taxable.
Yields: The factors of financial risk, interest rate risk, liquidity, and
taxability all influence the available yields on financial instruments.
***Look on page 447
Marketable Securities Alternative
Characteristics of the most widely used money-market securities
1. The denominations in which securities are available
2. The maturities that are offered
3. The basis used, for example, whether the security is sold at a
discount or offers coupon interest payments
4. The liquidity of the instrument, which relates principally to the
availability of a secondary market for the security
5. Taxability of the investment returns
Accounts Receivable Management
The importance of how a firm manages its accounts receivable
depends on the degree to which the firm sells on credit
The Percentage of the firms credit sales to total sales affects the level
of accounts receivable held. The nature of the business tends to
determine the blend between credit sales and cash sales.
The level of sales is also a factor in determining the size of the
investment in accounts receivable. The more sales, the greater the
accounts receivable.
The final determinant of the level of investment in accounts receivable
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are the firms credit and collection policies more specifically, the term
of the sale, the quality of the customer, and the collection efforts.
**The factors that determine the level of investment in accounts
receivable are on page 450
The terms of the sale a decision variable
Terms of sale: the credit terms identifying the possible discount for
early payment
Annualized opportunity cost of forgoing the discount = (a/1-a) x (360/cb)
The type of customer a decision variable
Default costs vary directly with the quality of the customer
Collection costs also increase as the quality of the customer declines
Credit scoring also evaluates the credit risks of individuals
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The numerical evaluation of credit applicants where the score is
evaluated relative to a predetermined standard.
o Inexpensive, and very easy to perform
**Look on page 451 for Edward Altmans equation
Collection Effort A decision variable
Eliminating past-due receivables is key. One common way of
evaluating the situation is with ratio analysis.
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Look at average collection period, the ratio of receivables to
assets, the ratio of credit sales to receivables, and the amount of
bad debts relative to sales over time.
Inventory Management
Inventory management: the control of assets used in the production
process or produced to be sold in the normal course of the firms
operations.
Types of Inventory
Raw materials: the basic materials purchased from other firms to be
used in the firms production operations
Work in process: partially finished goods requiring additional work
before they become finished goods
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Finished goods: goods on which the production has been completed
but that are not yet sold
Inventory Management Techniques
The Order Quantity Problem
Order quantity problem: determining the optimal order size for an
inventory item given its usage, carrying costs, and ordering costs.
Total inventory costs = total carrying costs + total ordering costs
Total carrying costs = (q/2)c
Q = the inventory order size in units
C = carrying cost per unit.
Total Ordering costs = (s/q)O
S = total demand in units over the planning period
O = ordering cost per order
***Look on page 455
Assumptions of the EOQ model
1. Constant, or uniform, demand
2. A constant unit price
3. Constant carrying costs
4. Constant ordering costs
5. Instantaneous delivery
6. Independent orders
The order point problem
Order point problem: determining how low inventory should be
depleted before it is reordered. Two points that go into determining an
appropriate order point:
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The procurement or delivery-time stock
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The safety stock desired
Safety stock: inventory held to accommodate any usually large and
unexpected usage during delivery time.
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Delivery time stock: the inventory needed between the order date and
the receipt of the inventory ordered.
Average inventory = (EOQ/2) + safety stock
There are several factors that determin how much delivery-time stock
and safety stock should be held.
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The efficiency of the replenishment system affects how much
delivery-time stock is needed.
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The more certain the patterns of these inflows and outflows from
the inventory, the less safety stock required.
Just-in-time inventory control system: a production and management
system in which inventory is cut down to a minimum through
adjustments to the time and physical distance between the various
production operations. Under this system the firm keeps a min level of
inventory on hand, relaying upon suppliers to furnish parts just in
time for them to be assembled.
Anticipatory buying: buying in anticipation of a price increase to secure
goods at a lower cost.