Chapter 27
CASH MANAGEMENT
SLIDES
CHAPTER WEB SITES
Section Web Address
27.2 www.carreker.fiserr.com
27.3 www.gtnews.com
27.4 www.toolkit.cch.com/tools/tools.asp
27.5 www.bloomberg.com
CHAPTER ORGANIZATION
27.1 Reasons for Holding Cash
The Speculative and Precautionary Motives
The Transaction Motive
Compensating Balances
Costs of Holding Cash
Cash Management versus Liquidity Management
27.2 Understanding Float
Disbursement Float
Collection Float and Net Float
27.1 Key Concepts and Skills
27.2 Chapter Outline
27.3 Reasons for Holding Cash
27.4 Understanding Float
27.5 Example: Types of Float
27.6 Example: Measuring Float
27.7 Example: Cost of Float
27.8 Cash Collection
27.9 Example: Accelerating Collections – Part I
27.10 Example: Accelerating Collections – Part II
27.11 Cash Disbursements
27.12 Investing Cash
27.13 Figure 19.6
27.14 Characteristics of Short-Term Securities
27.15 Quick Quiz
Float Management
Electronic Data Interchange and Check 21: The End of Float?
27.3 Cash Collection and Concentration
Components of Collection Time
Cash Collection
Lockboxes
Cash Concentration
Accelerating Collections: An Example
27.4 Managing Cash Disbursements
Increasing Disbursement Float
Controlling Disbursements
27.5 Investing Idle Cash
Temporary Cash Surpluses
Characteristics of Short-Term Securities
Some Different Types of Money Market Securities
ANNOTATED CHAPTER OUTLINE
Slide 27.1 Key Concepts and Skills
Slide 27.2 Chapter Outline
27.1. Reasons for Holding Cash
Slide 27.3 Reasons for Holding Cash
.A The Speculative and Precautionary Motives
Speculative motive – take advantage of unexpected opportunities
Precautionary motive – cash for emergencies
Lecture Tip: What is needed to satisfy the speculative and precautionary
motives is an ability to pay quickly – a need that is met with
liquidity. Although cash is the most liquid asset, assets such as
marketable securities are near substitutes for cash. The ability to
borrow quickly is also a close substitute for cash (having a line of
credit, for example).
Although holding cash and near-cash assets imposes opportunity costs on
the firm, it can be shown that the existence of this “financial
slack” is consistent with shareholder wealth maximization. The
ability to take advantage of unexpected, and often temporary,
financial opportunities is clearly valuable to the firm. Myers and
Majluf demonstrated in the Journal of Financial
Economics (1984) that the lack of financial slack could cause financial
decision makers to forgo positive NPV projects because of the
negative signal sent by issuing equity. The key is to find the
balance between financial slack and excess liquidity.
.B The Transaction Motive
Day-to-day cash requirements to meet expenses
.C Compensating Balances
Cash balances held as part of a loan agreement or as compensation for bank
services received
Lecture Tip: A compensating balance requirement serves both as a term of a
loan imposed by the lender and as compensation for services
rendered by the bank. As such, it is sometimes negotiable. For
example, the borrower can attempt to have the size of the required
balance reduced or negotiate the nature of the terms. Rather than
requiring that the company maintain $100,000 balance at all
times, the lender may agree to allow the firm to maintain an
average balance of $100,000 over a specified period. The latter
case gives the borrower more flexibility. You should also point out
that firms that normally hold significant amounts of liquid assets
do not find a compensating balance requirement constraining.
However, for many firms, it is cheaper to pay explicit fees to obtain
a loan than it is to maintain large no- or low-interest-bearing
accounts.
.D Costs of Holding Cash
The opportunity cost of holding cash is the return that could be earned by
investing the cash in other assets. However, there is also a cost to
converting between cash and other assets. The optimal cash
balance will consider the trade-off between these costs to minimize
the overall cost of holding cash.
Lecture Tip: It may be helpful to have students consider how they handle
their personal cash balances. Some may deposit their paychecks or
student loan proceeds in a non-interest-paying
checking account to use throughout the semester. Point out that they are
forgoing interest that they might receive on a savings account,
even though the balance might approach a low level by the end of
the term. If a student wants to maximize the interest earned on a
savings account, s/he must carefully monitor the checking account
balance to make sure that checks are able to clear. There is a
happy medium between having too much idle cash and too little.
Interest bearing checking accounts have mitigated the need for this
balancing act to some extent. The same concepts hold true for a
corporation.
.E Cash Management versus Liquidity Management
Liquidity management is a fairly broad area that concerns the optimal quantity
of liquid assets a firm should have, including accounts receivable
and inventory. Cash management deals with the optimization of the
collection and disbursement of cash.
27.2. Understanding Float
Book balance – the amount of cash recorded in the accounting
records of the firm
Available balance – the amount of cash the bank says is available
to be withdrawn from the account (may not be the same as the
amount of checks deposited less the amount of checks paid,
because deposits are not normally available immediately)
Float = Available balance – book balance
Slide 27.4 Understanding Float
.A Disbursement Float
Positive float implies that checks that have been written have not yet cleared.
The company needs to make sure that it adjusts the available
balance so that it does not think that there is more money to spend
than there actually is.
Disbursement float – generated by checks the firm has written that have not
yet cleared the bank; arrangements can be made so that this money
is invested in marketable securities until needed to cover the
checks
.B Collection Float and Net Float
Negative float implies that checks that have been deposited are not yet
available. The firm needs to be careful that it does not write checks
over the available balance, or the checks may bounce.
Collection float – generated by checks that have been received by
the firm but are not yet included in the available balance at the
bank
Managers need to be more concerned with net float and available balances
than with the book balance.
Slide 27.5 Example: Types of Float
Lecture Tip: It may help to personalize the issue of float. Ask the students if
they have ever written a check a day or two before receiving their
paycheck, even though, on the day when the check was mailed,
their checking account had insufficient funds to cover it.
This is an example of using disbursement float. We recognize that the time
for the check to travel through the mail and then be processed and
cleared should allow enough time for the paycheck to clear our
bank. We do need to be careful about this process, however. The
check we wrote may go through the system faster than anticipated,
and it may take the paycheck longer to become available than
anticipated. In this case, our check may bounce.
.C Float Management
The three components of float are:
Mail float – the time the check is in the mail
Processing float – handling time between receipt and deposit
Availability float – time for the check to clear the banking system
Float management – speeding up collections (reducing collection float) and
slowing down disbursements (increasing disbursement float)
Slide 27.6 Example: Measuring Float
There are two distinct cases for measuring float: (a) periodic collections and
(b) continuous or steady-state collections.
For periodic collections, average daily float = (check amount*days delay) / (#
days in period)
Example – Periodic Collections: Suppose a $10,000 check is mailed to Belief
Systems, Inc. every two weeks. It spends two days in the mail, one
day at Belief Systems offices and is credited to Belief Systems’
bank account two days after deposit, for a total delay of five days.
Over the 14-day period, the float is $10,000 for five days and $0
for nine days; then the cycle starts over. The average float is
(5*10,000 + 9*0)/14 = $3,571.43.
Example – Continuous Collections: Suppose average daily checks arriving at
Hector Company amount to $2,000. The checks take an average of
three days to arrive in the mail, one day to process and two days to
be credited to the bank account. The total collection delay is six
days, and the average daily float is 6*2000 = $12,000. Eliminating
all delays would free up $12,000; eliminating one day’s delay
would free up $2,000.
Lecture Tip: The Expedited Funds Availability Act (EFAA) governs the
availability of funds deposited by firms. The following rules apply
(based on US Code: Title 12 Section 4002 as of 1/23/00):
–Cash or electronic payment and government checks are
available the day after deposit.
-Local checks are available two days after deposit.
-Non-local checks are available five days after deposit.
Note that these rules indicate the maximum time for availability. Banks can
make funds available sooner if they choose. Also, deposits made at
ATMs can have a different schedule due to the processing time
required.
Cost of Collection Float: The benefit of reducing collection delays is directly
reflected in the change in average daily float. Every dollar
reduction in average daily float is a dollar freed up for use in
perpetuity. The change in the average daily float that any plan to
hasten collections might make is also the most the firm would be
willing to pay for faster collections.
Example – Periodic Collections: What is the most that Belief Systems would
pay to speed up collections by one day? If the collections delay
were reduced from five days to four days, the average daily float
would go from $3,571.43 to $2,857.14. So, the most the company
would be willing to pay is 3571.43 – 2857.14 = 714.29.
Example – Continuous Collections: How much would Hector save if they
reduced their collection delay from six days to three? The average
daily float for three days’ delay is $6,000, so the company would
save 12,000 – 6,000 = $6,000 and this is the most it would be
willing to pay.
Lecture Tip: The concept of net float can be emphasized with an example that
illustrates the changes in the balance sheet that result from an
increase in collection float and a decrease in disbursement float.
Consider a firm that has credit sales of $100,000 per day.
Inventory of $80,000 per day is purchased on credit. The company
has an average collection period of 30 days and an average
payables period of 20 days. The relevant balance sheet would be
as follows:
Accounts receivable = $3,000,000 (100,000*30)
Accounts payable = $1,600,000 (80,000*20)
This situation requires external financing of 3,000,000 – 1,600,000 =
$1,400,000. Checks, whether received or sent, have a three-day
delay in the mail. Therefore, the company has a net float of
–3*100,000 + 3*80,000 = -60,000. If the company could speed up
its receivables collection by one day and delay payments by one
day, net float would become positive (-2*100,000 + 4*80,000 =
120,000). The initial change to the balance sheet accounts would
be:
Additional Cash = $180,000
Accounts Receivables = $2,900,000
Accounts Payable = $1,680,000
The accounts receivable debit balance is reduced by $100,000 (source of
funds) and the accounts payable account is increased by $80,000
(source of funds). The net source of funds equals the change in
float, and the additional cash can be used to decrease the external
financing required.
Slide 27.7 Example: Cost of Float
Lecture Tip: The Institution Investor (September 1985) provides a lengthy
discussion of legal and ethical questions surrounding cash
management. The article, “Cash management: Where do you draw
the line,” by Barbara Donnelly, focuses on the E.F. Hutton check
kiting scandal. In retrospect, it is clear that the value of lost
reputation far exceeded the savings gained via the company’s cash
management strategies.
.D Electronic Data Interchange and Check 21: The End of Float?
EDI – exchanging information electronically.
A financial use is to send invoices electronically and then receive payment
electronically. Corporations spend substantial amounts on setting
up these systems. Most banks also offer these services, beyond just
on-line bill paying, to their retail customers.
27.3. Cash Collection and Concentration
.A Components of Collection Time
Collection Time = mailing time + processing delay + availability delay
.B Cash Collection
Cash collection policies depend on the nature of the business. Firms can
choose to have checks mailed to one or more locations (reduces
mailing time), or allow preauthorized payments. Many firms also
accept online payments either with a credit card, with authorization
to request the funds directly from your bank, or through online bill
paying arrangements.
Slide 27.8 Cash Collection
.C Lockboxes
Lockboxes are special post office boxes that allow banks to process the
incoming checks and then send the information on account
payment to the firm. They reduce processing time and often reduce
mail time because several regional lockboxes can be used.
.D Cash concentration
The practice of moving cash from multiple banks into the firm’s main
accounts. This is a common practice that is used in conjunction
with lockboxes.
.E Accelerating Collections: An Example
Slide 27.9 Example: Accelerating Collections – Part I
Slide 27.10 Example: Accelerating Collections – Part II
27.4. Managing Cash Disbursements
.A Increasing disbursement float
Slowing payments by increasing mail delay, processing time or collection
time. May not want to do this from either an ethical standpoint or a
valuation standpoint.
Slowing payment could cause a company to forgo discounts on its accounts
payable. As we will see later in the chapter, the cost of forgoing
discounts can be extremely high.
Slide 27.11 Cash Disbursement
Ethics Note: You may wish to emphasize the importance of ethical behavior in
this area of cash management. Because transactions occur
frequently and in large amounts, unscrupulous financial managers
tend to “cut corners” in this area more often than in some others.
Some corporations routinely pay late or take discounts that they do
not qualify for. This hurts the suppliers that the company does
business with and may ultimately hurt the company through a loss
of reputation or credit.
Ethical behavior can be summed up in the following rule of thumb
proposed by a top executive at a financial management seminar.
When asked about a practice similar to the one described above,
he responded that he followed the “mother rule” when faced with
a decision with ethical consequences – “If you would be
comfortable telling your mother what you did, it’s probably
ethical.” Of course, this doesn’t work for everyone, but it does hit
home with a lot of students.
.B Controlling disbursements
Minimize liquidity needs by keeping a tight rein on disbursements through
any ethical means possible
Zero-balance accounts – maintain several sub-accounts at regional banks and
one master account. Funds are transferred from the master account
when checks are presented for payment at one of the regional
accounts. This reduces the firm’s liquidity needs.
Controlled disbursement accounts – the firm is notified on a daily basis how
much cash is required to meet that day’s disbursements and the
firm wires the necessary funds.
27.5. Investing Idle Cash
.A Temporary cash surpluses
-seasonal or cyclical activities
-planned or possible expenditures
The goal is to invest temporary cash surpluses in liquid assets with short
maturities, low default risk and high marketability
Slide 27.12 Investing Cash
Slide 27.13 Figure 27.6
.B Characteristics of Short-Term Securities
Corporate treasurers seek to acquire assets with the following characteristics:
-short maturity
-low default risk
-high marketability
Slide 27.14 Characteristics of Short-Term Securities
Lecture Tip: “Marketability” suggests that large amounts of an asset can be
bought or sold quickly with little effect on the current market price.
This characteristic is usually associated with financial markets
that are “broad” and “deep.” Broad markets have a large number
of participants; deep markets have participants that are willing
and able to engage in large transactions. The market for U.S. T–
bills epitomizes these characteristics. There are millions of
potential buyers and sellers world-wide, and multi-million dollar
transactions are common.
.C Some Different Types of Money Market Securities
These include Treasury Bills, commercial paper, and CDs.
Lecture Tip: Current money market rates are available on a daily basis in
The Wall Street Journal. Various money market instruments and
their current rates can be found on the “Credit Markets” page in
Section C, under the title “Money Rates.” Remind students that
these rates change on a daily basis depending on market
conditions. This is also a good place to discuss the impact of Fed
decisions on short-term rates.
Slide 27.15 Quick Quiz.