CASH MANAGEMENT

BA 141
Business Finance I
 WORKING CAPITAL MANAGEMENT

Working Capital Management

 Management of current assets and current liabilities
 Trade-off between profitability and risk

High net working capital Low net working capital

Low profitability High profitability

Low risk High risk

Working Capital Management: Cash

 WORKING CAPITAL MANAGEMENT

Operating Cycle

AAI ACP

↑ Inventory ↑ Accounts ↑ Cash

↑ Accounts Receivable ↓ Accounts
Payable ↓ Inventory Receivable
APP

↑ Inventory ↓ AP
↑ Accounts Cash Conversion Cycle
↓ Cash
Payable

Working Capital Management: Cash

 CASH MANAGEMENT

Factors Considered in Cash Management

 Target cash balance
 Managing the “float”
 Managing cash receipts
 Managing cash disbursements
 Internal controls on cash
 Cash management models

Working Capital Management: Cash

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Target cash balance

 Factors to consider:
• Nature of business
• Level of operations
• Management style/motivation for holding cash

Working Capital Management: Cash

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Target cash balance

 Motives for holding cash:
• Transaction Motive
• Compensating Motive
• Precautionary Motive
• Speculative Motive

Working Capital Management: Cash

 CASH MANAGEMENT

Managing the “float”

 Float – delay on the funds that have been sent by the payer but are not yet usable funds to the payee
 Types:
• Mail float - the time delay between when payment is placed in the mail and when it is received
• Processing float - the time between receipt of a payment and its deposit into the firm’s account
• Clearing float - the time between deposit of a payment and when spendable funds become available to the
firm
 Net Float = Payment Float – Collection Float
 Minimize net float on collection but maximize net float on payment

Working Capital Management: Cash

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Illustrative Example
Print and Scan Corporation, a computer service provider, receives checks averaging P35,000 per day,
and it takes one day for the company to receive the checks from customers, one day for the deposit to
be made into the its bank account, and two days for the funds to become available to the firm, on
average. On the other hand, the firm also writes checks averaging P20,000 a day, but it takes, on average,
five days for suppliers to receive the check from the company, one day for the deposit to be made into
their respective bank accounts, and three days for the funds to become available to them.

What is Print and Scan Corporation’s net float in pesos?

Working Capital Management: Cash

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Illustrative Example

Payment float = P20,000 x (5 + 1 + 3) = P180,000

Collection float = P35,000 x (1 + 1+ 2) = P140,000
Net float = P180,000 – P140,000 = P40,000

Working Capital Management: Cash

 CASH MANAGEMENT

Managing cash receipts

 The average collection period has two stages:
• the time from the sale until the customer mails the payment
• the time from when the payment is mailed until the firm has the collected funds in its bank account

Working Capital Management: Cash

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Managing cash receipts

 Daily deposit of cash collections
 Electronic banking
 Wire transfer
 Collection services
• Lock box system - a collection procedure in which customers mail payments to a post office box that is
emptied regularly by the firm’s bank, which processes the payments and deposits them in the firm’s
account

Working Capital Management: Cash

 CASH MANAGEMENT
Illustrative Example
A banker has offered to set up and operate a lock box system for a Cashier Company. Details are given
below:
Average number of daily payments 325
Average size of payments P1,250
Daily interest rate 0.021%
Reduction in mailing time 1.5 days
Reduction in processing time 0.9 days
Bank charge per payment P0.30
Processing days per year 250 days

How much is the annual savings (loss) of Cashier Company on the use of the lock box system
above?

Working Capital Management: Cash

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Illustrative Example

Benefit = 325 x P1,250 x 0.021% x (1.5 + 0.9) x 250 days = 51,187.50

Cost = 325 x P0.30 x 250 days = 24,375
Net annual savings = 51,187.50 – 24,375 = P26,812.50

Working Capital Management: Cash

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Managing cash disbursements

 The average payment period has two stages:
• the time from the purchase until payment is mailed to the supplier
• the time from when the firm mails the payment to the supplier until it has the collected funds in its bank
account

Working Capital Management: Cash

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Managing cash disbursements

 Centralization of disbursements
 Controlled disbursing – lengthening the “float”
 Zero-balance account

Working Capital Management: Cash

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Internal controls on cash

 Cash collections should be deposited daily.
 Use a bank to safekeep cash.
 Disbursements should be made in checks rather than cash (except for small expenses which is
coursed through petty cash fund).
 Check and cash supporting documents should be pre-numbered and promptly submitted to the
relevant department/s.

Working Capital Management: Cash

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Internal controls on cash

 Monthly bank reconciliations should be prepared by accounting department.
 Cash monitoring is delegated to collecting officers.
 Access to cash should be restricted to authorized personnel only.
 Individuals with cash handling functions should be bonded and asked to take unannounced vacations.

Working Capital Management: Cash

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Cash management models

 Baumol model
 Miller-Orr model

Working Capital Management: Cash

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Baumol model
 a cash management technique with EOQ-like formula used for determining the optimal amount of
cash transfer, which is the amount that minimizes the total of transaction costs and opportunity
costs
 Larger cash transfer – Lower transaction costs and higher opportunity costs
 Smaller cash transfer – Higher transaction costs and lower opportunity costs

Working Capital Management: Cash

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Baumol model
Assumptions:
 Money can only be held or invested in marketable securities.
 The minimum cash balance is zero (no borrowing).
 Total cash requirements are known and constant.
 Cash is spent at a constant rate.
 The interest rate (opportunity cost of holding cash) per year and the transaction cost are constant
throughout the year.

Working Capital Management: Cash

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Baumol model
Formula:

2𝐷𝑇
𝐶 ∗=
where: 𝑖
C* – optimal amount of cash transfer
D – annual cash requirements
T – transaction cost
i – interest rate

Working Capital Management: Cash

 CASH MANAGEMENT

Illustrative Example
Pastel Company, a retailer of baked goods, requires P100,000 per month of cash in its business to
satisfy its various cash requirements. Investment in short-term securities earn 4% per annum. The costs
associated with each time investments are liquidated for cash is at P60 per transaction.

What is optimal annual cash transfer that Pastel Company should make under the
Baumol Cash Management Model?

Working Capital Management: Cash

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Illustrative Example

2𝐷𝑇 2 x 100,000 x 12 x 60
𝐶 ∗= = = 𝐏𝟔𝟎, 𝟎𝟎𝟎
𝑖 4%

Working Capital Management: Cash

 CASH MANAGEMENT

Miller-Orr model
 a cash management technique used for determining the optimal cash balance under the assumption
of uncertain cash inflows and outflows

Working Capital Management: Cash

 CASH MANAGEMENT

Miller-Orr model
Assumptions:
 Probability distribution of daily cash changes is at least approximately normal.
 Transaction cost per transfer is at a given fixed cost.
 Transfers between cash and marketable securities can be implemented simultaneously.
 Minimum cash balance is determined outside the model (depends on ability of firm to source funds
externally as required).

Working Capital Management: Cash

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Miller-Orr model
Range Points Nature of Demand Action
Upper Limit (UL) ℎ∗ + 𝐿𝐿 If cash level reaches UL, invest surplus cash (UL – RP)
Return Point (RP) 𝑧 ∗ + 𝐿𝐿 None
Lower Limit (LL) Set outside the model If cash level reaches LL, sell marketable securities for
cash (RP - LL)
where:
𝒉∗ = 3𝑧 ∗
1ൗ
2 3
3𝑏𝛿
𝒛∗ =
4𝑖
where:
𝒃 = cost per transfer
𝜹𝟐 = variance of daily changes in cash balance
𝒊 = daily interest rate on marketable securities

Working Capital Management: Cash

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Miller-Orr model

Working Capital Management: Cash

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Illustrative Example
The management of Playtech Co., a game development company, has set a safety cash balance of
P50,000. The standard deviation of the daily cash balance during the last year was P37,500, and the
transaction cost was P75 per transfer. The company also can invest idle cash in marketable securities at
an annual interest rate of 8%. Assume 365 days per year.

Determine the upper limit and the return point of Playtech Co. using the Miller-Orr cash
management model.

Working Capital Management: Cash

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Illustrative Example

𝒃 = P75
𝜹𝟐 = 37,5002 = 1,406,250,000
𝒊 = 8%/365 ≈ 0.0219178%
1Τ 1Τ
3𝑏𝛿 2 3 3 𝑥 75 𝑥 1,406,250,000 3
𝒛∗ = = = 71,197.15
4𝑖 4 𝑥 0.0219178%

𝒉∗ = 3𝑧 ∗ = 3 x 71,197.15 = 213,591.47

Working Capital Management: Cash

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Illustrative Example

UL = h* + LL = 213,591.47 + 50,000 = P263,591.47

RP = z* + LL = 71,197.15 + 50,000 = P121,197.15

Working Capital Management: Cash

END OF PRESENTATION