Managing Cash

 Objective of cash management

 Reasons for holding cash
 Costs of holding cash
 Controlling cash balance
 Cash budget
 Determining target cash balance (optimal cash
balance)
 Managing cash
 Managing colleting and disbursing cash
 Investing idle cash
 Managing Cash
 What is the objective of cash management?
 To keep the investment in cash as low as possible,
while
 ensuring the firms’ operation will not be
interrupted by cash shortage
 Reasons for holding cash
 Transaction motive
 Cash is need to meet the demand of firm’s normal
operations
 Examples are: paying suppliers, settlement of
debts when due, paying salaries and wages,
payment of operating expenses, taxes
 Reasons for holding cash
 Compensating balances
 Cash balances kept at commercial banks in order
to compensate the bank’s services for the firm.
 Usually with no or very low interest rate
 Reasons for holding cash
 Speculative motive
 Cash held to take advantage of unexpected
opportunities
 Precautionary motive
 A certain amount of cash set available for
emergencies
 Cost of holding cash
 Opportunity cost
 The cost of capital tied up in cash held by the firm
 The opportunity cost of excess cash is often
determined as the average interest income that
could be earned if cash is invested somewhere
else.
 Transaction (trading) costs
 Costs associated with transactions to raise cash
(e.g borrowing transaction, disposing investments
etc.)
Factors affecting the investment in cash
 Economic conditions
 The nature of the business
 The level of inflation
 The availability of near-liquid assets
 Relationships with suppliers
 The availability of borrowing
 The opportunity cost of holding cash
 The cost of borrowing
 Determining cash balance
 Preparation of cash budget
 Modeling target cash balance
 Preparing cash budget
 Cash budget is developed based on the forecast
of sources and use of cash for a future period
 Assumptions about firm’s activities and
economic conditions are necessary in
developing these forecasts
Preparing cash budget
 Determining optimal cash balance
 Various models may be used to determine
target cash balance
 These models involves the trade-off between
opportunity cost and trading costs of holding
cash
 Typical models
 Baumol–Allais–Tobin (BAT) model
 Miller-Orr model
 BAT model
Trading costs increase when the firm
Costs in dollars of must sell securities to meet cash needs.
holding cash

Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.

Trading costs
C* Size of cash balance
 BAT model
 The optimal cash balance is found where the
opportunity costs equals the trading costs
 Given
 T = The total amount of cash needed for the whole
period
 F = The fixed cost of raising cash (e.g. selling
securities)
 R = The opportunity cost of holding cash (i.e. the
interest rate)
 BAT model

Opportunity
Costs

Trading costs

C* Size of cash balance

 Miller-Orr model
 Baumol model has a limitation that it assumes
steady, certain cash outflows
 Under Miller-Orr model the firm allows its
cash balance to wander randomly between
upper and lower control limits
 Miller-Orr model
When the cash balance reaches the upper control limit U, cash is
invested elsewhere to get us to the target cash balance C
When the cash balance reaches the lower control limit, L, cash
is to be raised (e.g. selling investments) to get us up to the target
$ cash balance

U*

C*

As long as cash is between L and U*, no transaction is made. Time

 Miller-Orr model
 Given
 F = The fixed cost of raising cash (e.g. selling
securities)
 R = The opportunity cost of holding cash (i.e. the
interest rate)
 Lower limit “L” must be set by the firm
 σ2 is the variance (or squared standard deviation)
of cash flows per period
Miller-Orr model
 Methods in managing cash
 Managing the collection and disbursement of
cash
 Speed up cash collection
 Delay the disbursement of cash
 Investing idle cash
 Managing inventories
 Types of inventories
 Raw materials
 W.I.P
 Finished goods
 Purpose of holding inventories
 Meet the requirements of daily operations (for
production and sales)
 Make sure the normal operation is stable and not
interrupted
 Costs in managing inventories
 Various costs involved in storing and acquiring
inventories
 Carrying costs (holding cost)
 Storage and handling/tracking cost
 Opportunity cost
 Obsolescence, deterioration, or spillage
 Restocking costs (ordering costs)
 Transaction handling cost
 Delivery cost
 Managing and controlling inventories
 Various techniques may be applied to manage
and control inventories efficiently and
effectively
 ABC approach
 Economic order quantity model
 Materials requirement planning (MRP) systems
 Just-in-time (JIT) inventories management
 Managing inventories – ABC approach
 Classify inventory by cost, demand, and need
 Possible controlling principles
 Those items that have substantial transaction
(ordering) costs should be maintained in larger
quantities than those with lower ordering costs
 Generally maintain smaller quantities of expensive
items
 Maintain a substantial supply of less expensive
basic materials
Managing inventories – ABC approach
An example
 Managing inventory levels
 Money tied up in inventories does not earn
interest
 Inventory management aims at minimizing the
level of inventories held
Inventory movement pattern
 Costs of managing inventories
 A basic trade-off exists in inventory
management because holding costs increase
with inventory levels, whereas (re)ordering
costs decline with inventory levels
 The basic goal of inventory management is
thus to minimize the total of these costs
 Cost of managing inventories

Ordering
Costs
costs Total costs

Holding
costs

0 Q* Size of inventory order (units)

 Determining optimal order quantity
 Given
 D: total demand for inventories per period (in
units)
 H: cost of holding (carrying cost) 1 unit of
inventories per period
 C: cost per order
 Optimal order quantity can be determined
using Economic Order Quantity model
 Economic order quantity (EOQ) model
 Approach for establishing an optimal
inventory level
 The EOQ model minimizes the total cost of
holding and ordering inventories
 Total cost is minimized at the point where
holding costs equal ordering costs. Optimal re-
order quantity is calculated as:
 Extensions of EOQ model
 EOQ can be modified to take into account
other factors that have effects on inventory
management practice such as
 Safety level of inventories to avoid the risk of
shortage of stock in unforeseen events (safety
stock)
 Setting re-order point to make sure inventories are
available when needed
Extensions of EOQ model
Extensions of EOQ model
Extensions of EOQ model
 Other inventory management systems
 Materials requirement planning (MRP) system
 Just-in-time (JIT) inventories management
 Managing trade receivables (trade credit)

 Trade receivable arises from credit sales of

goods and services
 Involved with both costs and benefits
associated with credit sales activities
 Cost of bookkeeping customers’ debts
 Cost of collection of debts
 Bad debt
 Boosting sales
 Trade receivable management (credit
management) considers the trade-off between
increased sales and the costs of granting credit
 Trade receivables management
considerations
 Risk of non-payment
 Credit policies and analysis
 Who should be granted credit
 How much credit should be offered
 How long the credit is extended
 Is cash discount offered to accelerate early cash
payment
 Collection policies
 Administrative measures (collection letter, legal
action)
 Factoring
 Practice
 Examples 16.2 and 16.3 in the text book
 Managing trade payables
 Benefit
 Trade payable is “free-interest loan” from supplier
 Cost
 Cost of bookkeeping
 Administrative costs