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Chapter 5

Part II Current Assets Management

Cash &
The management of cash reserve, that is cash and marketable securities, is the utmost
important to small firms and others that are operating in a tight money supply in the

that is inability to meet current or maturing obligations. As any other financial decisions,
investment in cash reserves to maintain certain level of liquidity involves risk-return

High investments will leads to lower risk of insolvency, and lower returns. This is
because investment in cash and marketable securities offers little or no return.
Therefore, the goal is to minimize the level of cash reserve while maintaining adequate
level of liquidity. It involves:

1. Determine the appropriate degree of liquidity; that is the level of cash reserve
required. Higher liquidity represents lower risks.

2. Determine the appropriate mix of cash reserve; that is the balance between cash
and marketable securities. The decisions must account for the cost of converting
marketable securities to cash relative to its return.

The level of cash reserve depends on the certainty of firm's cash flows and the
management's attitude toward risk. Higher uncertainty of cash flows and risk-adverse
management will lead to lower risk strategy; that is holding high level of cash reserves
and vice versa.

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financial market. Cash reserves provide margin of safety against technical insolvency

Part II Current Assets Management

Chapter 5


Cash in form of currency and in current accounts is the most liquid of a firm's assets. It is
used to meet immediate day-to-day payments and other purposes. The firm has four
primary reasons for holding cash:


Transactions: The amount of cash that a firm needs to support day-to-day

operations is a function of the firm's sales level; that is a firm must have enough
cash on hand to make its day-to-day purchases of materials and pay all its


Precautionary: This need for holding cash is generally a function of the


predictability of a firm's cash inflows and outflows. The more unpredictable the
cash flows of the firm the greater the need for precautionary balances of cash.


Speculation: One reason a firm holds cash is to be able to take advantage of

any "bargains" that may arise.


Compensating Balances: These cash balances are held at banks to

compensate for services that they perform for the firm.

The recent development of liquid short-term investments, however, has diminished the
need for holding excessive precautionary and speculative balances. Many firms have
money market funds or portfolios of short-term securities that they can quickly convert to
cash should the need arise.

Cash Management Activity

The goal of cash management is to minimize the cash balance while maintaining certain
level of liquidity. Too much liquidity reduces return, whereas too little, increases risk
exposure. As outlined in Figure 5-1, cash management activity consists of several areas.

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Chapter 5

Figure 5-1

Part II Current Assets Management

The Cash Management Activity

Speeding up
Slowing down

Management of
firm cash flows

good banking

Determining the
optimal cash
Marketable securities
investment strategies for
cash excess

The cash management activity involves many aspects of the firm's operations. It relates
directly to the management of inventories, marketable securities portfolio, notes payable,
account payable, and account receivable. Therefore, the management of cash is of
utmost important to the firm as famous quotation puts it "the cash will take care of the
profits if the firm takes care of the cash."

Operating Cycle, Cash Cycle and Cash Turnover

The operating cycle (OC) is the lag time in days between the purchase of raw materials
and the time cash is collected from sales of finished goods or receivables.
Consequently, cash cycle (CC) is the lag time between cash outlay to purchase raw
materials or inventories and cash is collected from receivables. Therefore, CC is the
amount of time the firm's capital is tied up in inventories sold. To illustrate this concept,
refer to Figure 5-2 that shows the movement of goods and cash in a normal business

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short-term financing
strategies for cash


Chapter 5

Part II Current Assets Management

Figure 5-2

The Operating Cycle, Cash Cycle, and Cash Turnover

OC = 110 days
AAI = 70 days

Purchase Raw materials

Accounts payable




ACP = 40 days
Sell finished goods
Accounts receivable




Pay account payable

Cash outflows


APP = 30 days




100 110

Collect account receivable

Cash inflows

CC = 80 days

The cash cycle equals to:


= Average age of inventory (AAI) + Average collection period (ACP)

= 70 days + 40 days
= 110 days


= Average age of inventory (AAI) + Average collection period (ACP)

Average payment period (APP)
= 70 days + 40 days 30 days
= 80 days

Since cash cycle is a measure of the amount of time cash tied up; lower operating
cycle and cash cycle is better as the firm could recover the cash outlay in a shorter
period. Another measure of how effective cash is managed in the firm, is the cash
turnover (CTO). It refers to the number of times the firm's cash is actually turned over
each year and can be calculated as follows:

CTO0 = 360 /Cash cycle

= 360 / 80
= 4.5 times

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Part II Current Assets Management

The firm's cash cycles directly affect the amount of cash that need to be held at any
given time to support the operations. This amount represents the minimum operating
cash (MOC) to avoid any cash shortages in meeting all its payments. To illustrate
consider Indah Products has an annual cash expenditures or outlays of RM300,000,
then MOC:

MOC0 = Annual Cash Outlays / Cash turnover

= 300,000 / 4.5
= RM66,666.67

Therefore, Indah needs RM66,666.67 as a minimum cash requirement to support the

firm's day-to-day operations without risk of technical insolvency. This represents a large

turnover, without scarifying the firm's liquidity and profitability. Managing the basic
elements of cash cycle that is (1) accounts payable; (2) accounts receivable; and (3)
inventories can do this. Several strategies could reduce the cash cycles and
consequently increases its turnover:

1. Increasing Average Payment Period. It involves delaying payments on accounts

payable as late as possible (ALAP) without damaging the firm's credit rating. In
addition, favorable cash discount should not be ignored as the opportunity cost is
high if not taken.

2. Reducing Average Inventory of Age. This is to increase inventory turnover as

quickly as possible by (1) efficient management of inventories, (2) better production
planning, scheduling, and control, (3) effective sales forecasting, and (4) synchronize
the production and demand.

3. Reducing Average Collection Period. It involves speeding up collection of account

receivable as soon as possible (ASAP) without losing potential sales. The use of
proper techniques such as changes in credit policies and collection policies that will
improve collection period will benefits the company.

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investment for the company, and it is crucial to minimize cash cycle and maximize cash

Part II Current Assets Management

Chapter 5

The implementations of the above strategies will reduce cash cycles, and thus will result
in freeing some of the capital tied up in inventories and account receivable. The freed
capital that is available for other investment opportunities that could provide additional
return to the firm and/or reduces the cost of financing.

To illustrate, let assume that Indah in the above example able to:

1. Negotiate a better credit term with its suppliers from net 30 to net 35
2. Improve production process and selling effectiveness that reduces average age
of inventory by 10 days to 60 days.
3. Decrease average collection period by 7 days to 33 days by changing its credit



Other things held constant, the above changes are expected to improve the firm's
performance as it will result in lower of cash cycle, higher cash turnover and lower
minimum operating cash.

= 58 days.

CTO1 =
= 6.21 times

MOC1 =
= RM48,309.17

The above changes will have several impacts:

1. Shorter cash cycle, and thus higher cash turnover.

Change in CC = CC1 - CC0

= (22 days)

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Change in CTO

Part II Current Assets Management

= CTO1 - CTO0
= 1.71 times

2. Lower minimum operating cash requirements, and hence lower investment in

cash to support the firm's operations.

Change in investment


= MOC1 - MOC0
= (RM18,357.50)

3. Lower cost of financing and higher profits. If the cost of funds is at 10 percent,

Change in cost of financing

= Change in MOC x Cost of funds

= (RM1,835.75)

The effects of lower cash cycle are quite significant for large firms with cash reserves
and cash outlays that run in millions of Ringgits. Therefore, proper cash management
will have a direct impact on the firm's liquidity and profits. These represent a tradeoff that
needs to be balanced to ensure that all obligations are met without sacrificing the needs
for higher profits.


Although marketable securities typically provide much lower yields than firm's operating
assets, many firms hold large holdings of these securities. There are several reasons for
a firm holding these types of liquid assets:

1. Marketable Securities are a Substitute for Cash. In many cases, these securities
are held primarily for precautionary purposes. Most firms prefer to rely on bank credit

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the firm can realize a yearly saving of RM1,835.75.

Part II Current Assets Management

Chapter 5

to make temporary transactions or to meet speculative needs, but they still hold
some liquid assets to guard against a possible shortage of bank credit or to handle
possible emergencies.

2. Marketable Securities as a Temporary Investment. Often a firm uses these

securities as a temporary holding place for surplus cash flows. For example to hold
the proceeds from a long-term security issue until the funds can be used to purchase
operating assets.

Regardless of the motives, it will provide return from idle funds. In order to spread the
risk, marketable securities portfolio usually consists of different types of securities
with different maturity, liquidity, and returns.


Factors Influencing the Choice of Securities

A firm must consider several factors in choosing the marketable securities that it will

1. Default Risk. The risk that an issuer will be unable to make interest payments, or to
repay the principal amount on schedule, is known as default risk.

2. Interest Rate Risk. As we saw in Chapter 4, bond prices very with changes in the
interest rates; and in general, longer-term bonds tend to have more variability (or
interest rate risk) than shorter-term bonds.

3. Purchasing Power Risk. This is the risk that inflation will reduce the purchasing
power of a given sum of money. In general, real estate and common stock (whose
returns normally rise during inflation) are often thought of as better "hedges against
inflation" than the bonds and other fixed income securities.

4. Liquidity Risk. An asset that can be sold on short nice for close to its quoted price is
defined as being liquid. This particular quality is very important if a firm's need for
funds tends to be very volatile.

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5. Return on Securities. In general, the higher the risk of a given security the higher
the return on that security. Thus corporate treasurers, like other investors, must
make a tradeoff between risk, and return when choosing investments for their

Due to the required use of a firm's short-term portfolio, it should be of the highest quality.
Accordingly, the investments in this portfolio should be confined to safe, highly liquid,
short-term securities issued by either the U.S. government or the very strongest
corporations. Given the purpose of the securities portfolio, treasurers are unwilling to
sacrifice safety for higher rates of return.

In the money market, there are wide ranges of marketable securities available, which
carry various characteristics. Short- term securities can be grouped either as
government issues such as treasury bills, or private issues such as commercial paper.

Treasury bills (T-bills). Are a Government Issue, and therefore, the obligation of the
Treasury Department. Most of the T-bills matures in 91-182 days, with longer maturities
such as 9 months or one year are sold from time to time and in smaller amount. It is
auctioned weekly at a discount with the smallest denomination of RM1,000 and
considered as risk-free. Evaluations: High liquidity with strong secondary market, lowest
risk, and low return.

Treasury notes (T-notes). It is similar to T-bills, it is the obligations of the Treasury

department. However, its initial maturity is between 1 7 years. It is held in the
marketable securities portfolio because of security and liquidity. Evaluations: High
liquidity with strong secondary market, lowest risk, and returns is slightly higher than Tbill.

Negotiable certificate of deposits (NCDs). Is a negotiable instrument as an evidence

of deposit in a commercial bank. The amount (smallest RM100,000) and the maturity
(commonly 30 days) are based on the investor's (depositor's) needs. Evaluations: High

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Alternative investment

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Chapter 5

liquidity with strong secondary market, moderate risk that depends on the bank
involved, high return.

Commercial paper (CP). Commercial paper is a short-term unsecured promissory note

issued by a large firm with high credit standing. It maturities may range from 3 270
days, as longer maturities require a formal registration. Evaluations: Low liquidity with
weak secondary market, moderate risk that depends on the issuer, return is slightly
lower than CDs.

Banker's acceptance (BAs). It is similar to cashier's check payable in future, with

typical maturity of 30 days or 180 days. BAs result from a short-term credit arrangement
between purchaser and its bank to finance transactions. The purchaser with its bank
approval issues a draft, on which payment is contingent on some events, to the seller

for the amount purchased. The seller who holds BAs, then may sell it at a discount in
the secondary market to obtain immediate funds. Evaluations: High liquidity with strong
secondary market, moderate risks since it involves three parties, high return similar to

Other types of securities are available that can be part of the marketable securities
portfolio. The five securities presented above are the most commonly available and
demanded in the money market. As for the Malaysian context, the major money market
instruments are: (1) Bankers Acceptance, BA; (2) Negotiable Money market Instrument,
NCD; (3) Malaysian Government Securities, MGS is a long-term domestic borrowing;
(4) Malaysian Government Treasury Bills, MGTB is a short-term domestic borrowing;
and (5) Cagamas, unsecured bond issued by Perbadanan Cagaran Malaysia Berhad.

The cash and marketable securities management are highly dependent on each other,
and therefore it must be managed concurrently. These two liquid assets represent the
firm's storehouse of liquidity that aids its effort to maintain long-term viability and ability
to increase stockholders wealth.

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September 2002: Section B. Question 2(a)
Sri Temenggong Companys have an average age of inventories of 80 days, an average
collection period of 65 days and an average period of 30 days. The company spends RM
1 million per year. Assuming a 360-day cycle, calculate the firms:


Cash cycle

ii. Cash turnover

iii. Minimum operating cash balance the firm must maintain to meet its obligations.

September 2002: Section B. Question 5(b)

List two (2) types of marketable securities and briefly explain each of them.
(2 marks)

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(6 marks)

Part II Current Assets Management

Chapter 5

April 2003: Section B. Question 3(c)

a. Cik NH is planning to determine the firms minimum operating cash to reduce the
firms cost of investment. The firm is selling on terms net 45 and pays all credit
purchases on net 30. The firm takes 60 days to produce and sell the products. If the
firms yearly outlay is RM 500,000, calculate the:


Cash cycle

ii. Cash turnover (1 year = 360 days)

iii. Minimum operating cash


(5 marks)

March 2002: Section B. Question 2(a)

Jaya Berhad is planning to purchase raw materials on 5th April, 2002 and the payment
will be on credit term 5/10 net 30. The goods will be sold on 4th July, 2002. Sales of the
goods are RM60,000. Total accounts receivable are RM20,000 and total annual outlays
are RM30,000. You are required to find:


The cash cycle

ii) The cash turnover

iii) The minimum operating cash
(6+2+2=10 marks)

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September 2001: Section B. Question 5(b)

Clearly explain the three reasons of holding cash.
(5 marks)

April 2001: Section B. Question 2(b)

PCK Jurong Company, a producer of safety boot sells its merchandise on credit. The

manufacture, warehouse and ultimately sell finished goods (its average age of inventory

The average collection period (ACP) indicates that it is taking the firm on average 70
days to collect its account receivable and average payment period (APP) for raw
materials and labor is 30 days.

a. PCK Jurong Companys cash cycle.
b. PCK Jurong Companys cash turnover. Assume 360 days a year.
c. PCK Jurong Companys minimum operating cash, if the total annual outlay is

(15 marks)
October 2000: Section B Question 1 (b)
Write short notes on the following:

Malaysian government securities

Negotiable certificate of deposits
Commercial paper
Cagamas bond

(8 marks)

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companys operation department reveals that on average, it takes 40 days to

Part II Current Assets Management

Chapter 5

April 2000: Question 7(b)

Briefly, explain three factors that influence investment in marketable securities.
(3 marks)

April 99: Question 7(i)


Senang Company has inventory of 90 days, average collection period is 40 days,

and payment period is 30 days.
a) What is the length of firms cash cycle?

(3 marks)

b) If the companys annual sales are RM 4 million and 70% of the firms sales are
on credit, calculate the firms account receivable.
(3 marks)


c) Determine its cash turnover.

(3 marks)

April 97: Question 7

The LIT-TAK Corporation has an inventory age of 75 days, a receivable collection period
of 38 days and payment period of 30 days.
(a) What is the length of the firms cash cycle?
(b) If the companys annual sales are RM 3.375 million and 60 % of the firms sales are
on credit, what is the firms account receivable?
(c) What is its cash turnover?
( 6 marks)
November 1996: Question 4
(a) MH Company is planning to purchase raw materials on August 4, 1997 and the
payment will be on credit term 3/6 net 30. The goods will be sold on November 2,
1997. Sales of the goods are RM 60,000 with 60 % of it on credit. Total accounts
receivables are RM 10,000. Total annual outlays are RM 22,500. Find:

(i) the cash cycle

(ii) Cash turnover and
(iii) the minimum operating cash.
(Hint: Find the ACP first)

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( 8 marks)