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Discuss why firms hold cash and marketable securities, and how the levels they hold of each relate to those motives. Demonstrate the three basic strategies for the efficient management of cash using the firm’s operating and cash conversion cycles. Explain float, including its three basic components, and the firm’s major objectives with respect to collection float and disbursement float.
• Review popular techniques for speeding up collections and slowing down disbursements, the role of banking relationships, and international cash management. • Understand the basic characteristics of marketable securities and the key features of popular government and non-government issues. • Describe the Baumol model and Miller-Orr model and how they can be used to determine the optimum quantity in which to convert marketable securities and cash.
Cash is often called liquid assets or nonearning assets. raw materials. repayment of loan and others. It is needed to pay salaries. Specifically there are 3 major motives of holding cash which are: Transaction Motives Precautionary Motives Speculative Motives .
creditors and etc The funds needed to meet contingency requirement Funds needed to reserve for emergency needs. Requires the firm to maintain a minimum level of money it its bank account. normally based on a certain percentage of the loans taken. unforeseen fluctuation in cash flows or unexpected seasonal needs It serves as a safety cushion against the unexpected cash drain that may arise because of risk and uncertainty regarding the future To hold sufficient cash to enable the firm to take advantage of any unexpected bargain or opportunities which may arise from time to time such as trade discounts or some short term investments Are necessary to compensate financial institutions for providing loans and services. employees’ salaries. .Transaction motives Precautionary motives Speculative motives Compensating balances The level of funds required due to the ordinary course of business It is needed to meet ordinary payment such as paying bills.
It involves having the optimum amount of cash in hand at the right time It will also help the firm hold its cash longer and collect cash more quickly Reasons to have an efficient cash management techniques are: To establish proper procedures for collection from debtors and payment to creditors To establish adequate cash floats and minimum cash balances To synchronize cash inflows and outflows .
whereas too little.The goal of cash management is to minimize the cash balance while maintaining a certain level of liquidity. increases risk exposure. Too much liquidity reduces return. .
Cash Flow Management Estimation Cash Requirements Developing Borrowing/ Investment Strategies .
Slowing disbursements and speeding up collections can do this. .Involves the process of controlling the movement. of the firm to minimize the cash required to support working capital. inflows. and outflows.
and control the actual cash flow through the firm. .The estimation of cash requirements involves the preparation of cash budget. the appropriate level of cash holdings can be established. coordinate. which allow the firm to plan. Once the cash flow has been estimated.
. In case of cash excess.With the establishment of the appropriate cash balance. efficient investment strategies can be developed to use idle temporary liquidity and earn return. the strategies to finance any cash shortfalls can be developed ahead of time.
Speeding up receipts Slowing up disbursement Maintaining good banking relationship Management of firm’s cash flow Determining the optimal cash balances Cash budgeting Short-term financing strategies for cash shortfalls Marketable securities investment strategies for cash excess The cash will take care of the profits if the firm takes care of the cash. .
Make all payments as late as possible. . However. take advantage of any favorable discounts offered by suppliers. Make all collections as soon as possible without losing future sales and use cash discounts to encourage early payments.
.Turn over the inventory as quickly as possible and avoid stockouts that might result in shutting down the production line or any loss in sales.
Raw materials purchases (payable generated) Inventory processing Finished goods inventory Payment for purchases (payable exonerated) Payment received (receivable exonerated) Sale of goods (receivable generated) .
Therefore the firm must keep a minimum cash balance. .The objective of a firm is to run the business effectively without running out of cash. MOC will allow the firm to invest in various alternatives and to repay their debts when they are due.
.The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables.
The Cash Conversion Cycle (CC) is the time between when a firm pays it’s suppliers (payables) for inventory and collecting cash from the sale of the finished product. .
Company A OC = 110 days AAI = 70 days Purchase raw materials on credit Accounts Payable 0 10 20 30 40 50 60 70 ACP = 40 days Sell finished goods on credit Accounts Receivable 80 90 100 110 Pay accounts payable Cash Outflows Collect accounts receivable Cash Inflows APP = 30 days CC = 80 days .
OC = = AAI 70 days + + ACP 40 days = CC = = = = 110 days OC AAI + ACP 70 days + 40 days 80 days APP APP 30 days Where AAI = Average Age of Inventory ACP= Average Collection Period APP = Average Payment Period .
Cash cycle is a measure of the amount of cash tied up. A measure of how effective cash is managed in the firm is the cash turnover (CTO). lower operating cycle (OC) and cash cycle (CC) is better as the firm could recover the cash outlay in a shorter period. .
Refers to the number of times each year the firm’s cash is actually being turned over CTO = = = 360 CC 360 80 4.5 times .
The firm’s cash cycles directly affect the amount of cash that need to be held at any given time to support operations. This amount represents the minimum operating cash (MOC) to avoid any cash shortages in meeting all its payments. .
It is the minimum amount of money needed by the company per cycle MOC = Total annual cash outlay CTO .
666. .000.000 4.67 Therefore the firm needs RM66.5 RM66.666. MOC = = = Total annual cash outlay CTO 300.67 as a minimum cash requirement to support the firm’s day-to-day operations without risk of technical insolvency.Lets assume that the firm’s annual cash expenditures are expected at RM300.
Company A OC = 110 days
AAI = 70 days
Purchase raw materials on credit Accounts Payable
0 10 20 30 40 50 60 70
ACP = 40 days
Sell finished goods on credit Accounts Receivable
80 90 100 110
Pay accounts payable Cash Outflows
Collect accounts receivable Cash Inflows
APP = 30 days
CC = 80 days
Lets assume that Company A is able to negotiate a better credit term with its suppliers from 30 days to 35 days; Improve production and selling that reduces AAI to 60 days; Decrease average collection period to 33 days.
60 days 93 days
The changes resulted in a shorter operating cycle, cash cycle and thus a higher cash turnover.
= 60 days + 33 days = = = 58 days 360
6.21 times 300,000 6.21 = RM48,309.17 MOC =
Company A OC = 93 days AAI = 60 days Purchase raw materials on credit Accounts Payable 0 10 20 30 40 50 60 ACP = 33 days Sell finished goods on credit Accounts Receivable 70 80 90 100 110 Pay accounts payable Cash Outflows Collect accounts receivable Cash Inflows After APP = 35 days CC = 58 days .
The firm’s weighted average payment period (APP) for raw materials and labor is 35 days. The credit terms require customers to pay within 60 days of a sale. It also takes an average of 70 days to collect on its accounts receivable (ACP). . a producer of dinnerware. sells all its merchandise on credit. the average age of Inventory (AAI) is 85 days.MAX Company. The credit terms for MAX’s raw material purchases currently require payment within 40 days and employees are paid every 15 days. and ultimately sell a finished good. it takes 85 days to manufacture. Calculate the OC and CC. On average. warehouse. In other words.
As the firm increases its CC (through reducing the AAI and/or ACP and/or increasing the APP). the CTO will decrease and MOC cash will increase. .It is crucial for a firm to minimize its cash cycle and maximize cash turnover. without sacrificing the firm’s liquidity and profitability.
Favorable cash discount should not be ignored.Increasing Average Payment Period Involves delaying payments as late as possible without damaging the firm’s credit rating. as the opportunity cost is high if not taken. .
. scheduling and control Effective sales forecasting Synchronize the production and demand.Reducing Average Inventory Age Increase inventory turnover as quickly as possible by: Efficient management of inventories Better production planning.
The use of proper techniques such as changes in credit policies and collection policies that will improve collection period will benefit the company.Reducing Average Collection Period Involves speeding up collection of account receivables without losing potential sales. .
Proper cash management will have a direct impact on the firm’s liquidity and profits. .The effects of lower cash cycle are quite significant for large firms with cash reserves and cash outlays that run in millions of Ringgit.
Determining a firm’s desired cash level involves a tradeoff between the opportunity costs of holding too much cash and the costs of holding too little cash. .
Cost RM Carrying Cost Total Cost The minimum total costs occur where the carrying cost and trading cost is equal. the lower is the trading cost. Size of Cash Balance . Trading Cost The more a firm holds cash. This is the optimal cash balance that the firm should have.
• The cash conversion quantity depends on a number of factors. . and the firms demand for cash. including the fixed cost of transferring funds between cash and marketable securities.• Cash conversion models are used to help determine the optimal quantity of marketable securities to convert into cash when needed (and vice versa). • The objective of these models is to balance the costs and benefits of holding cash versus investing in marketable securities. the rate of interest.
. It is a trade off between opportunity cost/ carrying cost/ holding cost and the transaction cost.William J. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash. Baumol developed a model “The transactions Demand for Cash: An Inventory Theoretic Approach” which is usually used in inventory management and cash management.
Implications: The higher the interest rate (opportunity cost). . the higher will be the optimal cash balance. It does not take into account any seasonal or cyclical trends.Assumptions: Cash inflow and outflow are certain. the lower will be the optimal cash balances. The higher the trading cost.
Let us assume that the firm sells securities and starts with a cash balance of C Ringgit. its cash balance starts decreasing and reaches zero. When the firm spends cash. the average cash balance will be: Average Cash Balance = C 2 . The firm again gets back its money by selling marketable securities. As the cash balance decreases gradually.
This can be shown in following figure. .
The firm incurs a cost known as holding cost for maintaining the cash balance. the return inevitable on the marketable securities. then the firm’s holding cost for maintaining an average cash balance is as follows: Holding cost = k (C ) 2 . If the opportunity cost is k. It is known as opportunity cost.
The assumption here is that the cost per transaction is constant. then the total transaction cost will be: Transaction cost = c (T) C .e. T/C. it incurs a cost known as transaction cost. divided by the cash balance (C) i.Whenever the firm converts its marketable securities to cash. If the cost per transaction is c. Total number of transactions in a particular year will be total funds required (T).
k.Holding cost = k (C ) 2 Transaction cost = c (T) C Total cost = k (C) 2 x c (T) C Here. is the opportunity cost T is the total funds requirement C is the cash balance c is per transaction cost .
it can be said that there is a relationship between the holding cost and the transaction cost. The optimum cash balance.Optimum level of cash balance As the demand for cash. Hence. ‘C’ increases. . C* is obtained when the total cost is minimum. the holding cost will also increase and the transaction cost will reduce because of a decline in the number of transactions.
Formula for optimum cash balance C* = √ (2cT) k Where. . k is the opportunity cost of holding cash balances. C* is the optimum cash balance. T is the total cash needed during the year.
000 in cans outlays (demand) during the coming year. What is the firm’s optimal cash balance? .The management of JanCo.500. anticipates $1. a small distributor of sporting goods. The marketable securities portfolio currently earns an 8% rate of return. The firm has determined that it costs $30 to convert marketable securities into cash and vice versa.
• Balances that are too high will diminish profitability -. . • Although the more sophisticated mathematical estimation models are beyond our scope.and balances that are too low will accentuate risk. the goal of the firm is to maintain the level of cash and marketable securities that maximizes shareholder and firm value. the overriding objective is to balance risk against return.• Like other financial decisions.
.$20. • For example.000 -. if a company wishes to maintain $70. marketable securities serve as a safety stock of cash that can be deployed to satisfy unexpected demands for funds.000 would be held as marketable securities.• In addition to earning a return on temporarily idle funds.000 of liquid funds and a transactions balance of $50.
It is as liquid as cash as it takes a relatively short time for conversion to cash without losing face value. Acts as a cushion against technical insolvency. .Are near-cash items and considered as part of cash.
interest bearing money market instruments that can easily be converted into cash.Marketable securities are short-term. Securities that are most commonlyheld as part of a marketable securities portfolio can be segmented into two groups -.government issues and non-government issues. .
As a temporary investment Investments in marketable securities to: Finance seasonal or cyclical need for cash. . and Meet known future financial requirements.Reasons for holding marketable securities: As a substitute for cash For precautionary purposes as a cushion against unexpected shortage of bank credit and other emergency cash outflows.
Marketable securities portfolio consists of different types of securities that differ in: Maturity Liquidity Returns .
The choice of securities in the portfolio is in accordance to the nature of cash available for investment: Ready Cash Segment • For immediate cash needs Controllable • For expenditures that are predictable Cash Segment Free Cash Segment • For speculative purposes .
Security • Concerned with the safety of principal investment due to the risk of default in principal or interest payment and capital loss. . • Represents the tradeoff between risk and returns. Liquidity Yields • Refers to the ease of converting the securities to cash without losing the face value.
Treasury Bills (T-Bills) Treasury Notes (T-Notes) Negotiable Certificate of Deposits (NCDs) Commercial Paper (CP) Banker’s Acceptance (BA) .
Maturities not exceeding one year. The treasury holds weekly acution at a discount with the smallest denomination of RM1. . with longer maturity such as 9 months and one year. most of the T-bills mature in 91 – 182 days.000 and are considered as risk-free.It is a Government Issue and represents the obligation of the Treasury Department.
discount houses and finance companies. and low return. Provides investment outlets for short term surplus funds of commercial banks. lowest risk. . merchant banks.Payable to order and entitle the holder the payment of a fixed deposit sum on maturity. Evaluation: High liquidity with strong secondary market.
T-notes are part of marketable securities because of its security and liquidity. and return is slightly higher than T-bills. Maturity is between 1 – 7 years.Similar to T-Bills in that it is the obligation of the treasury Department. lowest risk. . Evaluation: High liquidity with strong secondary market.
A certificate of deposit. 1932 . USA.
A document which certifies that a certain sum of Ringgit has been deposited with a financial institution at a specified rate of interest with a specified maturity period. . Is a negotiable instrument as an evidence of deposit in a commercial bank.
) Evaluation: High liquidity with strong secondary market.The amount (smallest RM100. .000) and the maturity (commonly 30 days) are dependant on the investor’s (depositor’s) needs. moderate risk that depends on the bank involved and high return.
A short-term unsecured promissory note issued by a large firm with high credit standing. Maturity ranging from 3 – 270 days. Evaluation: Low liquidity with weak weak secondary market. . moderate risk (depending on the issuer) and return is slightly lower than NCDs. Longer maturity requires a formal registration.
Created out of a bona fide trade transaction such as to finance import and export of goods to/from Malaysia and sale and purchase of goods and services within Malaysia. Similar to cashier’s check payable in the future with typical maturity of 30 days or 180 days. .Bills of exchange which are drawn on and accepted by commercial or merchant banks in Malaysia.
issues a draft. on which payment is contingent on some events. . The seller who holds the BA may then sell it at a discount in the secondary market to obtain immediate funds.Arises from a short-term arrangement between a purchaser and its bank for financing of certain transactions. The purchaser with its bank approval. to the seller for the amount purchased.
In the Malaysian money market. major securities are: Bankers Acceptance Negotiable Money Market Instruments Malaysian Government Securities Malaysian Government Treasury Bills Cagamas Bonds .
therefore it must be managed concurrently.The cash management and marketable securities are highly dependant on each other. . These two liquid assets represent the firm’s liquidity that will determine its long-term viability and ability to increase stockholders’ wealth.
Financial Management by Rohani A. Ghani and Ibrahim Ab. Rahman. 2. UiTM Shah Alam. InED. InED. Ghani and Mohd Sabri Hj Mohd Amin. 3. UiTM Shah Alam. . UiTM.1. Financial Analysis by Omar Samad and Mohd Sabri Hj Mohd Amin. Financial Market and Institution by Rohani A. InED.
End of Chapter 6 .
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