Management of Cash and

Marketable Securities
Firms hold cash balances in checking
accounts. Why?

1. Transaction motive: Firms maintain cash

balances to conduct normal business
transactions. For example,
• Payroll must be met
• Supplies and inventory purchases must be paid
• Other day-to-day expenses of being in business
must be met
 Management of Cash and
Marketable Securities
2. Precautionary motive: Firms maintain
cash balances to meet precautionary
liquidity needs.

a. To bridge the gaps between cash inflow and cash

outflow
b. To meet unexpected emergencies
 Management of Cash and
Marketable Securities

3. Speculative motive: Firms maintain

cash balances in order to “speculate” –
that is, to take advantage of
unanticipated business opportunities that
may come along from time to time.
 Management of Cash and
Marketable Securities
4. Firms using bank debt are required to
maintain a compensating balance with the
bank from which they have borrowed the
money.
• Compensating balance: when a bank makes a
loan to a firm, the bank requires this minimum
balance in a non-interest-earning checking account
equal to a specified percentage of the amount
borrowed
• Common arrangement is a compensating balance equal to
5-10% of amount of loan
• Bankers maintain that existence of compensating balance
prevents firms from overextending cash flow position
because it forces them to maintain a reasonable minimum
cash balance.
 Management of Cash and
Marketable Securities
• Compensating balance raises effective interest rate on
loan.
• Numerical example:
– Bank charges 14% interest on P250,000 loan but
requires P25,000 compensating balance.
– Loan amount available to borrowers is 225,000
(250,000 - 25,000), but interest is charged on 250,000.
– Monthly interest payment rate: 1.167% (14%/12
months)
– Monthly interest cost: P2,917.50 (0.01167 x 250,000)
– Effective monthly interest rate: 1.297%
(2,917.50/225,000)
– Annual percentage rate: 15.56% (1.297 x 12 months)
 Management of Cash and
Marketable Securities
• Marketable securities: short-term, high-quality
debt instruments that can be easily converted
into cash.
• In order of priority, three primary criteria for
selecting appropriate marketable securities to
meet firm’s anticipated short-term cash needs
(particularly those arising from precautionary
and speculative motives):
1. Safety
2. Liquidity
3. Yield
 Management of Cash and
Marketable Securities
1. Safety
• Implies that there is negligible risk of default
of securities purchases
• Implies that marketable securities will not be
subject to excessive market fluctuations due
to fluctuations in interest rates
 Management of Cash and
Marketable Securities
2. Liquidity
• Requires that marketable securities can be sold
quickly and easily with no loss in principal value due
to inability to readily locate purchaser for securities
3. Yield
• Requires that the highest possible yield be earned
and is consistent with safety and liquidity criteria
• Least important of three in structuring marketable
securities portfolio
 Management of Cash and
Marketable Securities
Improving Cash Flow
Actions firm may take to improve cash
flow pattern:
1. Attempt to synchronize cash inflows and
cash outflows
– Common among large corporations
– E.g. Firm bills customers on regular schedule
throughout month and also pays its own bills
according to a regular monthly schedule. This
enables firm to match cash receipts with cash
disbursements.
 Management of Cash and
Marketable Securities
Improving Cash Flow
2. Expedite check-clearing process,
slow disbursements of cash, and
maximize use of “float” in corporate
checking accounts
• Three developments in financial services
industry have changed nature of cash
management process for corporate
treasurers
 Management of Cash and
Marketable Securities
Improving Cash Flow

3. Impact of electronic funds transfer systems

(EFTS) and online banking
• Includes so-called “remote capture” technology for
quickly depositing checks without visiting a bank
branch
• Radically reduced amount of time necessary to turn
customer’s check into available cash balance on
corporate books
• Sharply reduced amount of float available, as
corporation’s own checks clear more rapidly
 Management of Cash and
Marketable Securities
Improving Cash Flow

4. Expanded use of money market mutual

funds (as substitute for conventional checking
accounts)
 Management of Cash and
Marketable Securities
Improving Cash Flow
5. Growth in cash management services
offered by commercial banks
These systems efficiently handle firm’s cash
management needs at very competitive price.
 Accounts Receivable
Management
• Accounts receivable management requires
balance between cost of extending credit
and benefit received from extending credit.

• No universal optimization model to determine

credit policy for all firms since each firm has
unique operating characteristics that affect its
credit policy.
 Types Credit Policy

• Lenient/Liberal

• Stringent/Restrictive
Factors affecting the Credit Policy

• Credit Standards

• Credit Terms
 Credit Investigation
• “Five Cs” of credit analysis” used to decide
whether or not to extend credit to particular customer:
1. Character: moral integrity of credit applicant and
whether borrower is likely to give his/her best efforts
to honoring credit obligation
2. Capacity: whether borrowing firm has financial
capacity to meet required account payments
3. Capital: general financial condition of firm as judged
by analysis of financial statements
4. Collateral: existence of assets (i.e. inventory,
accounts receivable) that may be pledged by
borrowing firm as security for credit extended
5. Conditions: operating and financial condition of firm
Accounts Receivable Management
Types of cost:

1. Collection costs/Financing accounts

receivable
2. Offering discounts
3. Bad-debt losses
4. Carrying Costs
Accounts Receivable Management
• Supervising collection of accounts
receivable

– Requires close monitoring of average

collection period and aging schedule

– Aging schedule groups accounts by age and

then identified quantity of past due accounts
INVENTORY MANAGEMENT

GOAL: To provide the inventories

required to sustain operations at
the lowest possible cost.
Meaning, adequate stock in units at
minimum inventory cost.
 Inventory Management
Cost of maintaining inventory:
1. Carrying costs: all costs associated with carrying
inventory
• Storage, handling, loss in value due to
obsolescence and physical deterioration, taxes,
insurance, financing
2. Ordering costs:
• Cost of placing orders for new inventory (fixed
cost: same peso amount regardless of quantity
ordered)
• Cost of shipping and receiving new inventory
(variable cost: increase with increases in quantity
ordered)
 Inventory Management
Cost of maintaining inventory:

3. Stockout costs: the costs of running short

on inventory, including foregone income on lost
sales, cost of downtime, loss of customer
goodwill.
 Inventory Management
• Total inventory maintenance costs
(carrying costs plus ordering costs) vary
inversely.
– Carrying costs increase with increases in average
inventory levels and therefore argue in favor of
low levels of inventory in order to hold these costs
down.
– Ordering costs decrease with increases in
average inventory levels and therefore firm wants
to carry high levels of inventory so that it does not
have to reorder inventory as often as it would if it
carried low levels of inventory.
 Inventory Management
• Economic order quantity (EOQ) model:
mathematical model designed to
determine optimal level of average
inventory that firm should maintain to
minimize sum of carrying costs and
ordering costs (total cost inventory
maintenance cost)
– Explains inventory control problem
– EOQ = √2DO/C
 Assumption of EOQ Model
1. Annual demand requirements (sales) can
be forecasted perfectly.
2. Demand is evenly distributed throughout
the year.
3. No quantity discounts.
4. Instantaneous delivery.
 EOQ Model Extension
• Basic EOQ model assumes that inventory is used up
uniformly and that there are no delivery lags
(inventory is delivered instantaneously). Thus, two
modifications:
1. Establish reorder point that allows for delivery
lead times.
• Ex. If 2,700 units are ordered every 3 months
and normal delivery time is one month after order
is placed, then EOQ should be ordered when on-
hand amount drops to 900 units.
 Inventory Management
2. Add quantity of safety stock to base average
inventory that allows for uncertainty of estimates used
in model and possibility of non-uniform usage.
• This added quantity is dependent on degree of
uncertainty of demand, cost of stockouts, level of
carrying costs, and probability of shipping delays
• Ex. Adequate level of safety stock is 500 units.
Reorder point would be increased to 1,400 units
(900+500) and new order would be placed each
time on-hand quantity reached 1,400.
 Inventory Management
Example: Widget Wholesalers, Inc.
• Widgets sold per year: 240,000 units
• Cost price per unit: 2
• Inventory carrying costs: 20% of average
inventory level
• Fixed cost of ordering: 30 per order
 Inventory Management
• Solve EOQ = √(2DO/C)
– EOQ = √(2)(30)(240,000)/(0.20)(2)
– Widget should order 6,000 units per order.
– If Widget allows ten-day lead time, then
reorder point would be at 6,575 units (10 days
divided by 365 days times 240,000)
– At 6,000 units per order, Widget would place
forty orders per year (240,000/6,000)
 Short-Term Financing

• Spontaneous Financing
• Negotiated Financing
 Spontaneous Financing

– Accounts Payable (Trade Credit from

Suppliers)
– Accrued Expenses

Trade Credit - credit granted from one

business to another
 Spontaneous Financing
Examples of trade credit are:

• Open Accounts: the seller ships goods to the

buyer with an invoice specifying goods shipped,
total amount due, and terms of the sale.
• Notes Payable: the buyer signs a note that
evidences a debt to the seller.

• Trade Acceptances: the seller draws a draft on

the buyer that orders the buyer to pay the draft at
some future time period.
 S-t-r-e-t-c-h-i-n-g
Accounts Payable
Postponing payment beyond the end of the net
(credit) period is known as “stretching accounts
payable” or “leaning on the trade.”

Possible costs of “stretching accounts payable

• Cost of the cash discount (if any) forgone
• Late payment penalties or interest
• Deterioration in credit rating
 Cost of Trade Credit
• Nominal rate:
Discount 360 days
----------------------- X ----------------------------------
1 minus Discount Days CO minus Disc Period

• Effective rate:
Discount 360 days
( 1 + --------------------- ) ^ ---------------------------------- ) - 1
1 minus Discount Days CO minus Disc Period
 Accrued Expenses
Accrued Expenses -- Amounts owed but not yet paid for
wages, taxes, interest, and dividends. The accrued
expenses account is a short-term liability.

• Wages -- Benefits accrue via no direct cash

costs, but costs can develop by reduced
employee morale and efficiency.
• Taxes -- Benefits accrue until the due date,
but costs of penalties and interest beyond
the due date reduce the benefits.
Negotiated Financing
Types of negotiated financing:
• Money Market Credit
• Commercial Paper
• Bankers’ Acceptances
• Unsecured Loans*
• Line of Credit
• Revolving Credit Agreement
• Transaction Loan * Secured versions of these three loans
also exist.
 “Stand-Alone” Commercial
Paper
Commercial Paper -- Short-term, unsecured
promissory notes, generally issued by large
corporations (unsecured corporate IOUs).

• Commercial paper market is composed of the

(1) dealer and (2) direct-placement markets.
• Advantage: Cheaper than a short-term
business loan from a commercial bank.
• Dealers require a line of credit to ensure that the
commercial paper is paid off.
 “Bank-Supported”
Commercial Paper
A bank provides a letter of credit, for a fee,
guaranteeing the investor that the company’s
obligation will be paid.

• Letter of credit (L/C) -- A promise from a

third party (usually a bank) for payment in
the event that certain conditions are met. It
is frequently used to guarantee payment of
an obligation.
 Bankers’ Acceptances
Bankers’ Acceptances -- Short-term promissory
trade notes for which a bank (by having
“accepted” them) promises to pay the holder the
face amount at maturity.

– Used to facilitate foreign trade or the

shipment of certain marketable goods.
– Liquid market provides rates similar to
commercial paper rates.
 Short-Term Business Loans

Unsecured Loans -- A form of debt for

money borrowed that is not backed by the
pledge of specific assets.

Secured Loans -- A form of debt for money

borrowed in which specific assets have been
pledged to guarantee payment.
 Unsecured Loans
Line of Credit (rolled over) - An informal
arrangement between a bank and its
customer specifying the maximum amount of
credit the bank will permit the firm to owe at
any one time.
 Unsecured Loans
Revolving Credit Agreement (revolver
fund) - A formal, legal commitment to
extend credit up to some maximum
amount over a stated period of time.
 Cost of Bank Loans
• Simple Interest rate:
Interest
---------------------
Face Value

• Discount Interest rate:

Interest
--------------------------
Face Value- Interest
 Cost of Bank Loans
• Add-on Interest rate:
Annual Interest
---------------------------
Average balance

• Simple Interest w/ compensating bal:

Interest
-----------------------------------------
Face Value – Compensating bal
 Unsecured Loans

Transaction Loan - A loan agreement that

meets the short-term funds needs of the firm
for a single, specific purpose.
• Each request is handled as a separate transaction
by the bank, and project loan determination is
based on the cash-flow ability of the borrower.
• The loan is paid off at the completion of the project
by the firm from resulting cash flows.
 Secured (or Asset-Based)
Loans
Security (collateral) -- Asset (s) pledged by a
borrower to ensure repayment of a loan. If the
borrower defaults, the lender may sell the
security to pay off the loan.
Collateral value depends on:
• Marketability
• Life
• Riskiness
 Types of Inventory-Backed
Loans
Floating Lien -- A general, or blanket, lien
against a group of assets, such as inventory
or receivables, without the assets being
specifically identified.
Chattel Mortgage -- A lien on specifically
identified personal property (assets other
than real estate) backing a loan.
 Types of Inventory-Backed
Loans
Trust Receipt -- A security device
acknowledging that the borrower holds
specifically identified inventory and proceeds
from its sale in trust for the lender.

Terminal Warehouse Receipt -- A receipt for

the deposit of goods in a public warehouse
that a lender holds as collateral for a loan.
 Types of Inventory-Backed
Loans
Field Warehouse Receipt -- A receipt for
goods segregated and stored on the
borrower’s premises (but under the control
of an independent warehousing company)
that a lender holds as collateral for a loan.
 Financing the Accounts
Receivable
• Accounts receivable: used as collateral
for short-term loans
• Three methods of accounts receivable
financing:
1. Pledging
2. Assigning
3. Factoring