Unformatted text preview: ndividuals, businesses are not
thought to hold a significant amount of cash for speculative purposes.
6 Cross-reference: The current and quick ratios are discussed in Chapter 2, page 38. Chapter 12 Investing in Permanent Working Capital Assets 293 countries due to differences in financial customs: the frequency of credit card use,
the method by which workers are paid (cash or check), the convenience and cost
of the local banking system, and the significance of the underground economy.
Additional cash is kept in the form of demand (checking) deposits, which commonly earn a low or zero rate of interest and are also held to a minimum level.
Analytically, a firm’s optimal checking balance is a complex function of several
variables. Generally the balance increases with (1) volume of transactions including regular (payroll, purchases, taxes, dividends) and irregular (capital expenditures, debt retirement) flows and (2) variability of cash flows. It decreases
with (1) efficiency of cash management and (2) access to financial markets. Sometimes a firm holds a larger deposit balance than its analysis recommends because
of the requirements of a loan agreement.
Extra cash beyond the minimum required for currency and demand deposits is
normally invested to earn interest in bank time deposits or marketable securities.
Different currencies Companies operating multinationally also must decide
how much cash to maintain in each currency. The minimum requirement is to
keep enough cash for local operating and investment needs. Beyond that amount,
company treasurers must consider several additional issues. Cash is kept away
from any country in which local political intervention could block the firm’s ability to convert it and/or remove it. Cash is held in currencies that are expected to
increase in value and not in those that are expected to depreciate. One loss of
value comes from the fees incurred in exchanging currencies, so foreign exchange
transactions are typically kept to a minimum. Cash is also often moved to currencies where investments earn the highest interest rates.7
When a company does business in several currencies, it commonly “nets out” all
accounts receivable and accounts payable among its units. Thus, if Subsidiary A
owes $100 to Subsidiary B, and Subsidiary B owes $120 to Subsidiary A, the two
units will settle by B paying $20 to A. This reduces currency movements and exchanges, keeping their cost down.
Finance professionals debate the benefits of managing cash from a centralized
treasury department versus spreading out cash management responsibilities to a
firm’s operating units. In general, centralized cash management lessens the likelihood that one unit is holding excess cash while another is short and must borrow. One central account can serve as the precautionary balance for multiple locations. Borrowing costs are lowered as borrowing is done on a larger scale. Larger
and more frequent transactions provide treasury personnel increased experience
and expertise. On the other hand, decentralized cash management reduces the
number of times cash is moved among units. This lowers the transaction costs associated with currency movements and exchange. It also permits individual units
to establish and maintain better relationships with local financial institutions.
7 Elaboration and cross-reference: The only way to benefit from moving cash into a high-interestrate currency is to take the risk that the money can be exchanged back without loss of value. While
an aggressive treasurer will move cash balances among countries to benefit from high interest rates
and/or anticipated exchange rate movements, many treasurers choose not to expose their companies to these risks. 294 Part IV Adding Value 2. Managing Cash in Transit receivables float—the dollar
amount of incoming checks
that have been mailed but
have not yet been collected payables float—the dollar
amount of outgoing checks
that have been written but
have not yet been covered
by bank deposits Example Every dollar (or pound, or euro, etc.) of operating cash flowing through a company follows a similar path, diagrammed in Figure 12.3. The process begins when
a customer mails a check to the company, initiating a period of receivables float
during which “the check is in the mail.” Some days later, the company receives
the check and deposits it in its bank. Now the money is “in the company’s control,” and can be withdrawn and invested to earn interest. Later, when the company must pay a supplier, it writes a check; although it usually does not deposit
the amount back into its bank account until just before the check clears. The period between writing a check and the check clearing can be divided into a period
of payables float and a period during which the cash is sitting in the bank waiting to be paid out.
Receivables float cannot earn interest (although payables float normally does), nor
is it usual for money sitting in a demand account waiting to be paid out to earn
much interest. These amounts rep...
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