Chapter-3

Managing Cash and Marketable Securities

CASH MANAGEMENT
Dear student, in the previous chapter we have seen some basic concepts with regard to
management of working capital. This chapter is about how firms manage cash. Once the firm
has developed policies and strategies for the overall management of working capital, it can
turn its attention to the three primary assets that provide liquidity: cash, receivables and
inventory.
In the financial sense, the term cash refers all money items and sources that are readily
available to help pay firms bill. It includes currency, checking account deposits at commercial
banks, un deposited checks and short term marketable securities. Short-term marketable
securities are frequently referred to as “cash equivalents” and include treasury bills,
certificates of deposit, and repurchase agreements.
Cash is often called a “non-earning asset.” It is needed to pay for labour and raw materials, to
buy fixed assets, to pay taxes, to service debt, to pay dividends, and so on. However, cash
itself earns no interest. Thus, the goal of the cash manager is to minimize the amount of cash
the firm must hold for use in conducting its normal business activities, yet, at the same time,
to have sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to
meet unexpected cash needs.
OBJECTIVES OF CASH MANAGEMENT
The basic objectives of cash management are two, these are: -
1. To meet the cash disbursement need (payment schedule)
2. To minimize funds committed to cash balance (Minimization of Idle cash).
These two objectives are conflicting and mutually contradictory and it is the task of cash
management to reconcile them.
1. Meeting the payment schedule- in the normal course firms have to make payment of cash on a
continuous and regular basis to supplier of goods, employees and so on. At the same time there
is a constant inflows of cash through collection from debtors and cash sales. A basic objective of
cash management is to meet the payment schedule i.e., to have sufficient cash to meet the cash
disbursement needs of the firm. Keeping large cash balances however implies a high cost.
Sufficient and not excessive cash can well realize the advantages of prompt payment of cash.

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2. Minimizing funds committed to cash balance
High level of cash balance has the advantages of prompt payment but has high costs. A low
level of cash may result in not keeping up payment schedule but has low cost.
Excessive cash balance reduces profitability as well as lower cash leads to insolvency. As excess
cash or shortage has its own costs, an optimal cash balance would have to be arrived. This
optimal cash balance has to be arrived at after taking into consideration of the future cash
inflows and out flows. Using cash budget can derive an optimal cash balance.
Operating cash cycle
The cash operating cycle is the length of time, which elapses between a business paying for its raw
materials and the business’s customers paying for the goods made from the raw materials. It equals
the debtor’s collection period plus the length of time for which stocks are held, less the creditor’s
payment period.
The operating cycle is represented by the following sequences of events.
1. Purchase of material inputs
2. Conversion of raw materials into w/p
3. Conversion of w/p into finished goods
4. Sale of finished goods, Account receivable
5. Conversation of account receivable into cash
Cash cycle – refers to the time taken from the time cash is paid to purchase raw materials till the
time it is received from customers.
• Keeping the cash cycle so short is utmost important

Cash turnover – means the number of times firm’s cash is used during each year. Minimum
operating cash- the higher cash turnover, the less cash the firm requires. Therefore, the firm should
try to maximize the cash turnover but it must maintain a minimum amount of operating cash
balances so that it doesn’t run out of cash
Cash turn over = Number of days in a year
Cash cycle
• High turnover is desirable since it reduces firm’s average cash balance and holding costs.


Minimum cash balance = Total annual outlay
Cash turn over

The operational implication of the minimum cash requirement is that if the firm has an operating
minimum cash balance it would be able to meet its obligation when they become due.

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But the minimum operating cash involves cost in terms of the earning forgone from investing it
temporarily (i.e., opportunity cost). Also the firm will have to pay a cost for this amount.
Cash cycle= ACP + Manufacturing time – creditors payment period
Example.
Over the past year, X company’s accounts receivable have averaged 80 day sales and inventories
have averaged 60 days. The company has paid its creditors, on average, 25 days after receiving the
bill. Production is evenly spread over the year and the company expects to spend birr 18 million
during the year for materials and supplies
1. Compute the following Cash cycle
Cash turnover
Minimum cash balance
2. What is the birr cost of tying up the fund if the company’s opportunity cost is 20%?
Solution
1. a. Cash cycle = 80 + (60-25) = 115 days
b. Cash turnover = 365/115 = 3.18 times
c. Minimum cash balance = 18,000,000 = birr 566,038
3.18
2. Birr cost = 566,038, x 0.2 = birr 113,208

MOTIVES FOR HOLDING CASH
John Maynard Keynes, in his great work the “General theory of employment, interest and
money”, identified three reasons why liquidity is important: the speculative motive, the
precautionary motive and the transaction motive.
Transaction motive: - cash is needed to satisfy the transaction motive, the need to have cash on
hand to pay bills. Transactions related needs come from the normal disbursement and collection
activities of the firm. The disbursement of cash includes the payment of wages and salaries, trade
debts, taxes and dividends.
Precautionary motive (contingency needs) - is the need for a safety supply to act as a financial
reserve
-To maintain a safety cushion or buffer to meet unexpected cash needs. The more predictable the
inflows and out flows of cash for a firm, the less cash that needs to be held for precautionary needs.
Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash
balance

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Speculative motive (opportunity needs) – is the need to hold cash in order to be able to take
advantage of, for example, bargain purchases that might arise, attractive interest rates, and (in the
case of international firms) favorable exchange rate fluctuations.
- To take advantage of temporary opportunities, such as a sudden decline in the price of raw
material.
Compensating Motive:


Is a motive for holding cash/near-cash to compensate banks for providing certain services or
loans


Clients are supposed to maintain a minimum balance of cash at the bank which they cannot
use themselves. An organization has to maintain a minimum cash balance to meet cash
requirements.
ADVANTAGES OF HOLDING ADEQUATE CASH
In addition to the motives just discussed, sound working capital management requires that an ample
supply of cash be maintained for several reasons.
• It prevents insolvency or bankruptcy
• It helps in fostering good relationship with creditors and suppliers.
• To take available trade discounts
• It leads to a strong credit ratings. A strong credit rating enables the firm both to purchase
goods from suppliers on favorable terms and to maintain an ample line of low-cost credit
with its bank
• It is useful to take advantage of favorable business opportunities, such as special offer
from suppliers or the chance to acquire another firm.
• To meet unexpected expenditure with the minimum strain, like strikes, fires or
competitors marketing campaigns, and to weather seasonal and cyclical downturns.


CASH BUDGET
Cash budget shows the firm’s projected cash inflows and outflows over some specific period.
The cash budget is an integral part of the master budget of the business. It reflects the impact on cash
resources of budgeted sales, costs and changes in asset structure, and it also confirmation that the
plans are financially viable.
The objectives of cash budgets are:
• To integrate and appraise the effect of operating budgets on the company’s cash
resources.

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 • To anticipate cash shortages and surpluses, and to allow time to plan how to deal with
them.
• To provide a basis for comparison with actual, to identify unplanned occurrences.

MANAGING CASH COLLECTION AND DISBURSEMENT

Float: Difference between bank cash balance and book cash balance Float= Firm’s
bank balance- firm’s book balance
Float

Disbursement float Collection float


Checks received by the firm
 Checks written by firm Increase in book cash but no
 immediate change in bank
Decreased in book cash but no immediate
balance
Change in bank balance
Net float= disbursement float + collection float

Example:
Disbursement float
XYZ co. currently has birr 1,000,000 on deposit with its bank. The book balance also shows birr
1,000,000. Assume that XYZ co. Purchased materials and make payments by writing a check for birr
100,000

The book balance is immediately adjusted to $ 900,000 when the check is issued.


The bank balance will not decrease until the check is presented to XYZ’s bank by the supplier
or his bank.
Disbursement float = Bank balance – book balance

= 1,000,000 – 900,000 = 100,000

Collection float
Consider the same example above, but instead of payment, the firm receives a check from a
customer for $ 200,000 and deposits the check at its bank. Book balance is adjusted immediately to $
1,200,000
Bank balance will not increase immediately until XYZ’s bank present the check to the customer’s
bank and received the amount

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 Collection float = Bank balance - book balance

= 1,000,000 – 1,200,000 = -200,000

Net float = 100,000- 200,000 =- 100,000

Float result an opportunity cost because the cash is not available for use during the time checks are
tied up in the collection process.
FLOAT MANAGEMENT
It involves controlling the collection and disbursement of cash. The objective in cash collection is to
speed up collections and reduce the lag between the time customers pay their bills and the time the
cash becomes available. The objective in cash disbursement is to control payments and minimize the
firm’s costs associated with making payments.
Total collection or disbursement times can be broken down into three parts mailing time, processing
delay, and availability delay.
1. Mailing time is the part of the collection and disbarment process during which checks are trapped
in the postal system.
2. Processing delay is the time it takes the receiver or the check to process the payment and deposit it
in a bank for collection
3. Availability delay refers to the time required to clear a check through the banking system.
DETERMINING THE TARGET CASH BALANCE
The target cash balance involves a trade-off between the opportunity costs of holding too much cash (the
carrying costs) and the costs of holding too little (the shortage costs, also called adjustment costs). The nature
of these costs depends on the firm’s working capital policy.
Cash holding
Benefit- liquidity
Cost- interest for gone
If a firm tries to keep its cash holding too low, it will find itself running out of cash more often than is
desirable, and thus selling marketable securities (and perhaps later buying marketable securities to replace
those sold) more frequently than would be the case if the cash balance were higher. Thus trading costs will be
high when the cash balance is small. These costs will fall as the cash balance becomes larger.

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 1. THE BAT MODEL

The Baumol-Allais-Tobin (BAT) model is a classic means of analyzing our cash management problem. It is a
straight forward model and, more generally, current asset management

Implicitly, we assume that the net cash out flow is the same every day and that it is known with certainty.
These two assumptions make the model easy to handle.

Because transactions costs (for-example, the brokerage costs of selling marketable securities) must be
incurred whenever cash is replenished, establishing large initial balances will lower the trading costs
connected with cash management. However, the larger the average cash balance, the greater the opportunity
cost (the return that could have been earned on marketable securities)

To determine the optimal strategy, a company needs to know the following things.

F= the fixed cost of making a securities trade to replenish cash

T= The total amount of new cash needed for transactions purpose over the relevant planning period, say, one
year

R= the opportunity cost of holding cash. This is the interest rate on marketable securities.

C= Amount of cash raised by selling securities or borrowing, evenly spaced.

The opportunity costs: - To determine the opportunity costs of holding cash, we have to find out how much
interest is forgone. A company has, on average, C/2 in cash. This amount could be earning interest at rate R.
So the total dollar opportunity costs of cash balances are equal to the average cash balance multiplied by the
interest rate.
Opportunity cost= (C/2) x R

The trading costs: - To determine the total trading costs for the year, we need to know how many times a
company will have to sell marketable securities during the year. It is determined by T/C. It costs F dollars
each time; so trading costs are given by
Trading costs= (T/C) x F

The total cost: - Now that we have the opportunity costs and the trading costs, we can calculate the total cost
by adding them together
Total cost= opportunity cost + Trading costs

= (C/2) x R + (T/C) x F

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 Opportunity costs = Trading costs
(C*/2) x R = (T/C*) xF

C*XC* = (2T xF)

R
C*2 = (2T x F)
R
C* = √2T x F
R
The BAT model is possibly the simplest and most stripped-down sensible model for determining the optimal
cash position. Its chief weakness is that it assumes steady, certain cash out flows

Example: - ABC co. has cash out flows of $100 per day, seven days a week. The interest rate is 5 percent, and
the fixed cost of replenishing (restocking) cash balances is $10 per transaction. What is the optimal cash
balance? What is the total cost? T= 365 x days x 100 = $ 36,500

C* = (2T x F) = (2x36,500 x 10) = $ 14.6 million

R 0.05

= $ 3,821

The average cash balance (C*/2) is $ 3,821/2 = $ 1,911, so the opportunity cost is $ 1,911 x 0.05 = $ 96.
Because a company needs $ 100 per day, the $ 3,821 balance will last $3,821/100 = 38.21 days the firm needs
to re supply the account 365/38.21 = 9.6 times per year, so the trading (order) cost is $ 96. The total cost is
$192.

Investing idle cash

If a firm has a temporary cash surplus, it can invest in short term securities. The market for short-term
financial assets is called the money market. The maturity of short-term financial assets that trade in the
money market is one year or less.

Firms have temporary cash surplus for various reasons. Two of most important are the financing of seasonal
or cyclical activities of the firm and the financing of planned or possible expenditures.

Seasonal or cyclical activities: - Some firms have predictable cash flow pattern. They have surplus cash
flows during part of the year and deficit cash flows the rest of the year. Such firm’s may buy marketable
securities when surplus cash flows occur and sell marketable securities when deficits occur. Of course, bank
loans are another short-term financing device.

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Planned or possible expenditures: firms frequently accumulate temporary investments in marketable
securities to provide the cash for a plant construction program, dividend payment, or other large expenditure.
Thus firms may issue bonds and stocks before the cash is needed, investing the proceeds in short-term
marketable securities and then selling the securities to finance the expenditures. Also firms may face the
possibility of having to make a large cash outlay. An obvious example would involve the possibility of losing
a large lawsuit. Firms may build up cash surplus against such a contingency.

Selecting investment opportunities

A firm can invest its, excess cash in many types of securities or short-term investment opportunities. As the
firm invests its temporary cash balance, its primary criterion in selecting a security or investment
opportunities will be its quickest convertibility into cash, when the need for cash arises. Besides this, the firm
would also be interested in the fact that when it sells the security or liquidates investment, it, at least gets the
amount of cash equal to investment out lay. Thus, in choosing among alternative investment, the firm should
examine three basic features of security safety, maturity and marketability.

Safety: usually, a firm would be interested in receiving as high return on its investment as is possible. But the
higher return yielding securities or investment alternatives is relatively more risky. The firm would invest in
very safe securities, as the cash balance invested in them is needed in near feature. Thus, the firm would tend
to invest in the highest yielding marketable securities subject to the constraint that the securities have
acceptable level of risk. The risk referred here is the default risk. The default risk means the possibility of
default in the payment of interest or principal on time and in the amount promised.

Maturity: It refers to the time period over which interest and principal are to be made.

Long term security – more fluctuation in interest rate
- More risky

Short term security

For safety reasons it is preferred by the firm for the purpose of investing
excess cash.
Marketability: It refers to convenience and speed with which a security or an investment can be converted
into cash. The two important aspects of marketability are price and time.

Types of short-term investment opportunities

 
Bank deposits
Treasury bills

 Inter-corporate deposits
Commercial papers
Money market mutual funds

Certificate of deposits


Refer :- van Horne fundamentals of Financial Mgt chap 9 Page 221-244