Cash Management

I. Cash Management
A. Cash management is the process by which a firm collects, invests, and administers its cash.
Accounting, finance, and treasury departments work together to ensure the organization
uses cash efficiently and that cash is available for operating and capital investment needs.
B. Cash management policies are focused on managing a firm's liquidity needs, that is, the
ability of a firm to convert assets into cash without loss of value when needed. Efficient cash
management optimizes the timing of cash inflows and cash outflows.
C. Cash management systems are built around the cash conversion cycle, which is the period
of time over which a firm converts its cash outflows for its products and services into cash
inflows.

II. Holding Cash

A. Firms maintain cash balances, sometimes very large cash balances, for a variety of reasons.
i. The transaction motive – means that firms have cash reserves in order to make
payments related to their business operations. Firms pay cash for materials, labor,
operating expenses, and many other expenses. Without cash to engage in financial
transactions, firms struggle to maintain continuing business operations.
ii. The precautionary motive – means that firms have cash reserves for unexpected or
emergency cash needs. Firms can forecast expected cash needs; however, it is
difficult to be accurate in forecasting. Having extra cash available allows firms to
experience unanticipated cash needs without damaging business operations.
iii. The compliance motive – means that firms have cash reserves in order to comply
with cash balance requirements from loans and other bank services. Referred to as
compensating balances, these requirements benefit the bank providing the loan or
service by providing access to the firm's deposit interest free.

III. Forecasting Cash Flows

a. A key tool for managing cash flow is to make forecasts of cash inflows and cash outflows.
Anticipating the timing of cash flows can help firms determine their cash needs and where
their cash will be invested. The cash budget is a budgeting tool that helps firms map out
their expected cash collections and cash disbursements along with any financing needs.
b. When preparing cash flow forecasts, the following are important considerations:
i. Credit Terms Received – The terms such as interest rates and payment-due dates
vendors or suppliers are willing to extend on accounts payable. These terms affect
the timing of cash outflows.
ii. Credit Terms Extended – In like manner, firms extend credit to their customers. The
interest rates and payment-due dates extended to customers affect the timing of
cash inflows.
iii. Payment forms – firms have a variety of options to complete financial transactions
that affect the timing of cash flows. Paying hard cash is the quickest cash outflow,
followed by checks, and then by credit cards. The variation in processing time from
payment type can make a significant difference in a firm's cash flow management.
iv. Inventory Needed – Inventory represents a more illiquid asset. It requires cash be
invested and then held as inventory until the product is sold. The average time that
inventory is held before being converted into cash affects the timing of a firm's
forecasted cash flows.

IV. Collecting Cash

a. Firms create collection systems to gather and deposit cash. Firms can collect payments in
many forms such as cash, check, debit or credit card, and electronic transfers.
 Collection float is a measure of the time from when a transaction is initiated until the cash is
available for use. For example, when a check is mailed to a firm, the collection float is
broken down as follows:
i. Mail float – the time from when the check is mailed to when the firm receives the
check
ii. Processing float – the time from when the firm receives the check to when it is
deposited
iii. Availability float – the time from when the check is deposited to when the funds are
made available to the organization

b. A lockbox system is an arrangement between a bank and a firm that allows geographically
dispersed customers to send their payments to a post office box near them. The payments
are then collected and processed by the bank. Because the payment skips the firm's
location, the collection float is reduced. In the case of mailed checks, the bank generally
provide photocopies or electronic scans of the checks along with payment remittance forms
to the firm. The primary drawback of a lockbox system is the cost of administering the
system, which can include post office box rental fees, account or deposit fees, and
processing fees.

c. The net benefit of a lockbox system is the dollar value of reduced mail and processing float
less the costs of the system. A firm benefits from a lockbox by accelerating cash collections,
which allow the firm to earn interest on the cash sooner than it otherwise would.

Example – Value of a Lockbox

Consider a firm that uses a lockbox system that costs $0.30 per processed check. The firm
receives an average of 100 checks per business day with an average value of $1,000. The
firm estimates the lockbox reduces processing by 2 days. If there are 270 business days per
year and the firm's account receivable costs 5% in interest to the firm, what is the net
benefit of the lockbox system?

Cost of the Lockbox = 100 checks × $0. 30 per check × 270 days = $8, 100
Savings from the Lockbox = 2 days × 5% × ($1, 000 per check × 100 checks) = $10, 000

The net benefit to the firm is $1,900 per year by using the lockbox system.

d. Payment systems use digital means to bypass the traditional system of mailing checks for
payment. Automated clearinghouse (ACH)transactions process and settle payments
electronically. In the United States, the Federal Reserve is the primary ACH operator.
Fedwire, operated by the Federal Reserve, provides financial institutions the ability to
transfer funds through their respective Federal Reserve bank accounts.

e. Firms will often use a concentration banking system. This system transfers all funds from a
variety of regional banks into a single central banking account. It simplifies the cash
management process because firms can focus on one bank account rather than multiple
accounts.

V. Disbursing Cash
a. Organizations use disbursement systems to pay employees, suppliers, tax agencies, and
other external stakeholders. Disbursement float is a measure of the time between when a
firm initiates payment and when the funds are deducted from the firm's bank account.
Disbursement float is similar to collection float, but it also adds clearing float, which is the
 time between when the other party deposits the firm's check and when the amount is
officially deducted from the firm's bank account.
b. Firms can use a variety of methods to control disbursement activities.
i. A zero-balance account (ZBA) allows a bank to write checks against an account with
no money in it. A daily transfer from the bank's master account covers any checks
written. Firms may have multiple ZBAs for supplier payments, tax payments, wages,
etc. ZBAs allow for decentralized payables activity and the elimination of excess cash
in multiple bank accounts.
ii. Centralized payables allows a firm to use a single bank account and take advantage
of economies of scale from a single payment location.
iii. A payable through draft (PTD) requires a bank to present the instrument to the firm
for final acceptance. The firm then will deposit funds to cover the draft. This service
incurs higher charges for the firm but allows the firm greater management over its
cash funds.
iv. Electronic commerce (e-commerce) facilitates relationships and transactions
digitally. Processing payments online reduces cycle time and has lower error rates.
Accounts Receivable Management

I. Managing Accounts Receivable

a. Firms often extend credit to customers by delivering the product or services now in exchange for a
promise of future payment. This arrangement benefits firms because it makes it easier and more
likely that customers will make purchases, and depending on the credit terms, the firm can earn
interest.

b. The amount of accounts receivable a firm has is affected by several factors, including the following:
i. Credit Screening — Firms can evaluate customers’ creditworthiness. For example, firms may
require customers have a minimum credit score in order to receive financing. Firms incur
costs for credit screening, and as such, firms vary in the extent to which they screen
customers.
ii. Credit Terms — Firms can determine the interest and term length. Lower interest rates and
longer payment periods will increase the likelihood customers use credit to finance their
purchases. For example, a common credit term is 2/10, net 30, which means a customer
receives a 2%discount if it pays in 10 days, and it must pay its receivable in 30 days.
iii. Monitoring Collections — Once credit is extended to a customer, the firm must make efforts
to collect the promised money. Firms vary in how actively they remind customers to pay.
iv. Default Risk — The risk that customers will not pay their bill. This is related to the initial
credit screening, but can also be affected by subsequent events that affect a customer's
ability to pay their bills.

c. The goal of a firm's credit policy is to increase sales while also realizing cash collections. Firms
expect a portion of their credit sales to be uncollectible, but the firm's credit policy should seek to
optimize the tradeoff between increasing sales and the amount of cash not recovered by collection.

d. The average collection period (or the days sales in receivables) measures how much time passes
between a sale and the time a customer pays. A firm can measure average collection period as a
weighted average of the times customers pay.
i. For example, if 20% of customers pay in 10 days, 60% pay in 30 days, and 20% pay in 60
days, the average collection period is (20% × 10) + (60% ×30) + (20% × 60) = 2 + 18 + 12 = 32
days.

e. The firm's average balance in receivables is calculated as the Average Daily Sales × Average
Collection Period
i. For example, if the firm's average collection period is 32 days and average daily sales are
$20,000, the average balance in A/R is ($20,000 × 32 days)= $640,000.

f. The Accounts Receivable Turnover Ratio measures the number of times the company cycles its A/R
each year. The formula is Annual Net Credit Sales ÷Average Receivables Balance.
i. For example, if a firm had $7,200,000 in credit sales and had an average receivables balance
of $640,000, the accounts receivable turnover ratio would be 11.25 = ($7,200,000 ÷
$640,000).

g. A common tool use to manage accounts receivable is an aging schedule. This schedule maps out
the accounts receivable by how far past the initial sale they are. It is used to help identify and track
delinquent accounts. The older a receivable is, the greater likelihood that it will not be collected.
Inventory Management

I. Managing Inventory

a. Inventory management starts with the purchase of raw materials and ends with the sale of finished
goods. Firms have inventory on hand or in storage facilities for several reasons, such as the following:
i. Protect against suppliers’ financial uncertainty or shipping delays.
ii. Mitigate the risk of stock-outs because of high demand
iii. Ensure the firm can operate in an efficient and effective manner.

b. Firms attempt to minimize total inventory cost while carrying sufficient inventory to maintain
operations. This can be a difficult managerial problem due to the complexity of forecasting sales demand,
availability of raw materials, and production processing. Firms must balance several costs when
determining the optimal inventory level to carry. These costs include the following:

i. Purchasing costs —The actual amount that a firm pays for materials. This can include shipping
and taxes on the goods purchased.
ii. Carrying costs —The warehouse space, handling costs, insurance, taxes, and depreciation
associated with storing inventory.
iii. Ordering costs —The costs of purchasing departments, administrative support, and other fixed
costs associated with placing orders with suppliers.
iv. Stock-out costs —The lost revenue (an opportunity cost) associated with not being able to fulfill
customers’ orders in a timely manner.

c. Firms spend considerable time and resources to determine the right quantity of inventory to carry
because inventory is a significant investment and can result in reduced cash flow if not managed well. If a
business wants to minimize stock-out costs, it will incur higher carrying and ordering costs. In contrast,
firms seeking to minimize carrying and ordering costs will risk incurring larger stock-out costs from not
having the right inventory on hand.

d. The following key terms are important to understanding how firms design their inventory purchasing
and management strategies.
i. Lead-time - is the time between when a firm places an order with a supplier and when the goods
arrive at the business.
ii. Safety stock - is protection against increased demand and should be calculated to balance the
volatility of demand with the risk the firm wishes to incur for stock-out costs. It is the amount of
inventory a firm has on hand beyond the projected sales amount.
iii. The reorder point is calculated as: (Average Daily Demand in Units × Lead Time) + Safety Stock
For example, a firm has daily demand of 1,000 units, requires lead-time of 30 days, and wants a
safety stock of 3 days’ worth of inventory. The reorder point is (1,000 × 30 days) + 3,000 units =
33,000 units.

II. Just-in-Time Inventory Management

a. Just-in-time (JIT) systems help firms manage inventory and reduce cost. Firms contract with
suppliers to deliver inventory only on order when the firm requires it. In other words, JIT can be
considered a “pull” inventory system wherein demand is the trigger for inventory ordering rather
than predetermined inventory levels. The philosophy behind a JIT system is different from
traditional inventory systems in that it regards inventory storage as a non-value-added activity.
Thus, JIT attempts to reduce or eliminate the carrying costs of inventory.
b. JIT systems were pioneered by Japanese firms like Toyota Motor Company. Most auto
manufacturers now employ a JIT system. Firms with JIT systems benefit from having little to no
 carrying costs and not having the risk of inventory obsolescence. However, firms with JIT systems
are very dependent upon their suppliers and their ability to deliver goods as needed.

III. Inventory Turnover

a. Firms can also manage inventory costs by increasing their inventory turnover. High inventory turnover
ratios mean that firms move their inventory from raw materials to sales more quickly. When firms have
high inventory turnover ratios, they incur fewer overhead expenses in these areas:
i. Fewer employees required to handle and move material
ii. Lower utility costs because the firm requires less space to store inventory
iii. Less depreciation expense or rent expense related to handling equipment, such as forklifts

Lower overhead expenses from having high inventory turnover means cost of goods sold will be lower,
which in turn improves a firm's gross margin.

IV. Economic Order Quantity

a. Firms can use the economic order quantity (EOQ) model to calculate the order quantity that minimizes
the total costs incurred to order and hold inventory. If a firm carries less inventory, it will order more and
have higher ordering costs. Firms carrying more inventory may make fewer orders, but these firms will
have more costs with warehousing, handling, and depreciation required to store and carry inventory.

b. The formula for EOQ is given as follows: EOQ = √[(2 × Reorder Costs × Sales per Period) ÷ Carrying Costs]

c. The EOQ model has several key assumptions: (1) demand remains uniform, (2) ordering costs and
carrying costs are constant, and (3) no quantity discounts are allowed.

d. Calculations using the EOQ are not required on the CMA exam, but an understanding of the concept and
its features is expected.