CHAPTER 5

CASH OR LIQUID ASSET MANAGEMENT

CHAPTER CONTEXT: THE BIG PICTURE

This chapter introduces the process of liquid asset management and is the first chapter in the
four-chapter section entitled “Part 2: Managing Your Money.” This section of the text introduces
different strategies for controlling the financial plan through cash management, credit
management, and management of large expenses. Cash management lays the foundation for
maintaining adequate liquidity to meet everyday expenses and avoiding the sale of other assets
to meet emergency expenses. Specifically, this chapter introduces the principles of liquid asset
management and describes the alternatives available for cash management and liquid
investments. Students are encouraged to critically evaluate the products and to tailor choices to
best match their needs.

CHAPTER SUMMARY

This chapter establishes the importance of implementing an effective cash management plan. A
basic premise of the chapter is the importance of maintaining some liquid assets to be used in the
event of an emergency. Cash management institutions, their features, and the characteristics of
the accounts offered are summarized. Rates of return on different cash management and liquid
investment alternatives are discussed. Strategies for selecting and using cash management
vehicles, such as the checking account, are discussed. An explanation of the benefits of
automating cash management with electronic funds transfers and online banking concludes this
chapter.

LEARNING OBJECTIVES AND KEY TERMS

After reading this chapter, students should be able to accomplish the following objectives and
define the associated key terms:

1. Manage your cash and understand why you need liquid assets.
a. cash management
b. liquid assets
2. Automate your savings.
3. Choose from among the different types of financial institutions that provide cash
management services.
a. deposit-type financial institutions
b. non-deposit-type financial institutions
c. online banking

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4. Compare the various cash management alternatives.

a. demand deposit
b. NOW (negotiable order of withdrawal) account
c. savings account
d. money market deposit account (MMDA)
e. certificate of deposit (CDs)
f. money market mutual funds (MMMFs)
g. asset management accounts
h. U.S. Treasury Bills, or T-Bills
i. denomination
j. U.S. Savings bond
5. Compare rates on the different liquid investment alternatives.
a. annual percentage yield (APY)
b. after-tax return
c. Federal Deposit Insurance Corporation (FDIC)
d. National Credit Union Association
6. Establish and use a checking account.
a. direct deposit
b. safety deposit box
c. overdraft protection
d. stop payment
e. cashier’s check
f. certified check
g. money order
h. traveler’s checks
7. Transfer funds electronically and understand how electronic funds transfers (EFTs) work.
a. electronic funds transfer (EFT)
b. automated teller machine (ATM), or cash machine
c. personal identification number (PIN)
d. debit card
e. smart cards

CHAPTER OUTLINE

I. Managing Liquid Assets

A. The reservoir effect
B. Risks associated with liquid assets
1. Risk-return trade-off
2. Spending risk

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 Cash or Liquid Asset Management 95

II. Automating Savings: Pay Yourself First

A. Automatic deposit
B. Payroll deduction

III. Financial Institutions

A. “Banks” or deposit-type financial institutions
1. Commercial banks
2. Savings and loan associations
3. Savings banks
4. Credit unions
B. Non-deposit-type financial institutions
1. Mutual funds
2. Stock brokerage firms
C. Online Banking
1. Instant access
2. Transfers
3. Pay bills
D. What to look for in a financial institution
1. Service
2. Safety
3. Cost

IV. Cash Management Alternatives

A. Checking accounts
1. Demand deposits
2. Negotiable order of withdrawal accounts
B. Savings accounts
1. Passbook accounts
2. Statement accounts
C. Money market deposit accounts
D. Certificates of deposit
E. Money market mutual funds
F. Asset management account
G. U.S. Treasury bills, or T-bills
H. U.S. Series EE bonds
1. Denominations
2. Tax advantages

V. Comparing Cash Management Alternatives

A. Comparable interest rates
B. Tax considerations
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C. Safety
1. Federal Deposit Insurance Corporation (FDIC)
2. Money market mutual funds and safety

VI. Establishing and Using a Checking Account

A. Choosing a financial institution
B. The cost factor
1. Monthly fees
2. Minimum balances
3. Charge per check
4. Balance-dependent scaled fees
C. The convenience factor
1. Safety deposit boxes
2. Overdraft protection
3. Stop payments
D. The consideration factor
E. Balancing your checking account
1. “Check 21”
F. Other types of checks
1. Cashier’s check
2. Certified check
3. Money order
4. Traveler’s check

VII. Electronic Funds Transfers (EFTs)

A. Automated teller machines (ATMs)
B. Debit cards
C. Smart cards
D. Stored value cards
E. Fixing mistakes—theirs, not yours

APPLICABLE PRINCIPLES

Principle 5: Stuff Happens or The Importance of Liquidity

Unforeseen events require you to have liquid assets to protect your other investments.
Rather than being forced to sell the investment at a loss to cover the emergency expense,
you can simply pay in cash.

Principle 8: Risk and Return Go Hand in Hand

Because liquid assets, such as a savings account or money market mutual fund, can be easily
converted to cash, they have very little or no risk. But these accounts also don’t provide a
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 Cash or Liquid Asset Management 97

high return. Nevertheless, low-risk, high-liquidity investments are an integral part of your
cash management plan. Just don’t keep too many assets in these accounts.

Principle 10: Just Do It

Establish a savings habit by having savings automatically deducted from your paycheck.
The “if you don’t see it, you won’t spend it” adage has a lot of truth to it and can eventually
pay great rewards—even when considering the low returns associated with liquid accounts.

Principle 3: The Time Value of Money

The earlier you start saving, the greater the effect compound interest has on the investment
return. Start saving immediately; time is your greatest ally—even more important than how
much you save.

CLASSROOM APPLICATIONS

1. Ask students to list several reasons why starting to save immediately after employment (or
other life cycle event such as marriage, birth of a child, or divorce) can be difficult. Discuss
the reasons why saving, regardless of the amount, is beneficial and should be strongly
encouraged.

2. Innovations and automations in cash management accounts, online banking, and electronic
fund transfer options continue to evolve. For example, future ATM machines may “read”
the user’s retina instead of a PIN. Ask the students to locate recent news articles to update
the class on the latest innovations and automations.

3. Ask the class to collect brochures, newspaper or magazine advertisements, or other

information on various liquid asset accounts. While working in small groups, have the
students create appropriate consumer scenarios from across the financial life cycle to match
to each account. Remind them to consider rate of return, length of investment period, and
minimum deposit in their answers. Are some accounts simply not good choices when
compared to others available?

4. Have the class do online research to compare “Web-based” banks to traditional “brick and
mortar” institutions. Ask students to compare the types of accounts offered, the fees
imposed, the rates of return, the services available, and the privacy of client data. With the
class, discuss the drawbacks associated with “Web-based” banks and why these institutions
would or would not be a viable alternative for individual banking needs. For interest, divide
the class into small groups, with each representing a bank of their choice.

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98 Chapter 5

REVIEW QUESTION ANSWERS

1. Liquidity is the ability to easily convert certain financial products, such as checking
accounts, money market funds, and CDs, into cash. It is important to have liquidity because,
as Principle 5 says, “Stuff happens.” By keeping some funds in liquid assets, money is
available to cover financial emergencies such as unemployment or car repairs. That way,
long-term investments (e.g., stock) do not have to be sold at an inopportune time, perhaps at
an unfavorable price. Liquid assets are also used to hold money used for paying normal
household living expenses (e.g., rent, utilities). Unfortunately Principle 8 refers to the risk-
return trade-off, because with higher liquidity comes lower return. So there will be some
loss of earnings potential with highly liquid accounts.

2. Student answers may vary; however, the following are some characteristics:
• Can quickly be turned into cash without loss of principal.
• Considered low-risk assets (compared to other investments).
• Provide a relatively low expected rate of return.
• Useful for holding funds that you expect to use in the near future.
• A good place to put an emergency fund of three to six months’ expenses.
• Very sensitive to interest rate changes taking place in the economy.

Some disadvantages of having too much money too liquid are:

• Low overall return due to low investment risk.
• Risk of spending due to ease of access.

Some disadvantages of having too little money too liquid are:

• Higher liquidation cost in the event of an emergency.
• Greater amount of time to receive the money.
• Increased risk of not having access.

3. The two factors are (1) less government regulation (deregulation) and (2) increased
competition between banks and other financial institutions.

4. The primary advantage of automating your savings is best addressed with Principle 10: Just
Do It. According to this idea, it is easier to spend than save. If you automate your savings,
then you are creating an expense for your savings plan, and you are not as likely to neglect
it.

5. Deposit-type institutions (a.k.a. banks) provide traditional checking and savings accounts
and offer the most variety in financial services, including safe deposit boxes, credit cards,
and a wide array of savings and loan options.
• Commercial banks
• Savings and loan associations
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 Cash or Liquid Asset Management 99

• Savings banks (a.k.a. mutual savings banks, credit unions)

Non-deposit-type financial institutions have more recently (since deregulation in the early
1980s) begun to offer similar services to compete with banks, while banks have begun to
offer services traditionally provided by non-deposit institutions (e.g., securities purchases).
Thus, over the past two decades, traditional lines between the two types of financial
institutions have blurred considerably.
• Mutual funds
• Stock brokerage firms
• Insurance firms

6. Student answers may vary but should be drawn from the following lists.
• Advantages
1. Personal financial management support from financial planning programs
2. Convenience
3. Efficiency
4. Effectiveness
• Disadvantages
1. Increased start-up time
2. Adapting to online banking may have a steep learning curve for some
3. Not feeling comfortable
4. Little or no customer-service

7. A credit union is a non-profit, depositor-owned financial institution made up of members

with some type of common bond (e.g., employment, religion, college affiliation). Credit
unions offer a wide range of competitive financial services (e.g., loans, checking accounts).
Characteristics of credit unions:
• Due to “affiliation requirement,” only about half of Americans are eligible to join.
• Often smaller and more efficient than commercial banks.
• Tend to have lower fees and minimum balances than banks.
• Loans tend to be made at more favorable rates.
• Some do not provide home mortgages.
• Very convenient: often located at members' place of employment.

8. NOW stands for “negotiable order of withdrawal.” NOW accounts are checking accounts in
which you earn interest on your balance. Generally, you must maintain a certain minimum
balance in order for interest to be paid.
• Advantage: Extra income provided by an interest-bearing account.
• Disadvantage: Owners must generally place more money in a checking account than
needed to pay bills in order to meet minimum balance requirements. There is an
opportunity cost associated with interest that could have been earned on alternative,
higher-paying investments.

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9. The characteristics of CDs include:

• CDs pay a fixed rate of interest for a specified period of time.
• Generally, the longer the time period until maturity, the higher the rate of return.
• If money is withdrawn prior to maturity, an early-withdrawal penalty may be assessed.
• CD rates vary from bank to bank and between banks and other financial institutions

10. A money market deposit account (MMDA) is a bank product that provides a variable rate of
interest that fluctuates with market conditions. Up to three checks per month can be written
against the account without incurring additional charges. Often, a minimum balance of
$1,000 or more is required to open an MMDA and they are FDIC insured. A money market
mutual fund (MMMF) is an investment company product (not FDIC insured) and also
provides a variable rate of interest. The issuer pools the funds of many investors and invests
the fund portfolio in short-term debt instruments issued by government entities or large
corporations. Limited check writing is also available (checks must exceed a certain amount,
such as $250 or $500). Minimum initial deposits vary. MMMFs almost always pay a
slightly higher yield than bank MMDAs.

11. Asset management accounts are a comprehensive financial services package, offered by
brokerage firms, that provide a single consolidated monthly financial statement and
coordinate the flow of cash between MMMFs and other investments in the account. That
way, no money sits idle without earning interest. Components of an asset management
account can include a checking account, a credit card, securities such as stocks or bonds, a
MMMF, and automatic loan payments. Interest and dividends earned on investments are
swept into the MMMF daily to immediately earn additional interest.

However, not everything about these accounts is beneficial. Their annual cost is about $50
to $125, which may or may not be worth the benefits provided. Another disadvantage is
that these accounts typically have fairly high minimum balances and, of course, you must
pay a commission to purchase any investments.

12. Treasury bills (T-bills) are short-term federal government debt instruments with maturities
ranging from 3 months to 12 months. The minimum denomination to purchase a T-bill is
$10,000. T-bills are purchased at an amount less than the face value received at maturity.
The difference between the purchase price and the face value is the interest paid to an
investor. T-bills are taxable on federal tax returns but are free from state or local taxes.

EE bonds are issued in denominations ranging from $50 to $10,000. They are purchased at
half of their face value. Like T-bills, interest grows until maturity and they are state tax free.
Rates for both products vary with market conditions. Interest may be exempt from federal
tax if EE bonds are used to pay college tuition and fees and income limits are met.

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13. Generally, the higher the investors’ marginal tax bracket, the more they'll benefit from tax-
exempt investments such as municipal bonds. This is because taxes affect the real rate of
return on investments by taking away some of the yield earned by investors in taxable
securities. To decide on the best investment alternative (taxable versus tax-exempt),
investments should be compared on an equivalent after-tax basis.

14. The factors are typically referred to as the three Cs:

1. Cost (e.g. Return item charges, Service charges, Minimum balance requirements)
2. Convenience (e.g. Location, Hours, Available services)
3. Consideration (e.g. Personal service, Safety)

15. Electronic funds transfers (EFTs) are financial transactions that take place electronically. In
other words, money is quickly moved between accounts without the use of paper (e.g.,
checks). Three types of EFTs are ATMs, debit cards, and smart cards.
• ATMs—an acronym for automatic teller machines, ATMs provide cash withdrawals
through the use of credit or debit cards. They are convenient and available worldwide.
Fees of up to $4 can be charged per transaction, making ATMs an expensive way to get
money if used frequently.
• Debit Cards—a cross between a credit card and a checking account, a debit card allows
you to spend money on deposit in a specific account linked to them. Unless you have
overdraft protection, you can't spend more than you have in the account.
• Smart Cards—smart cards magnetically store a specific dollar value that is put into the
card when users deposit funds with the issuer. Smart cards can then be used to purchase
services from vendors who honor them. Frequent issuers include universities,
restaurants, and copy machine services (e.g., Kinko’s).

16. Features of online banking include: 24-hour access, extended customer service hours, and
online statements. Disadvantages include: no physical location for problem resolution, any
personal relationship with your banker, and lack of features, such as safe deposit boxes.

Features of debit cards include: nearly universal acceptance and check-like convenience.
Debit cards have almost no disadvantages, unless you consider super-easy access to your
money a disadvantage.

Features of “smart” cards include: 24-hour usage, reduced need for cash, and almost
universal acceptance. The only disadvantage may be that you are prepaying for your
expenses, which reduces your time value of money.

There are two primary types of stored value cards: 1) closed-loop, single purpose cards such
as prepaid calling cards or gift cards and 2) open-loop, multi-purpose cards like prepaid
debit cards. The primary disadvantage of the cards is the wide variety of fees associated

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with their use. These fees include: activation, maintenance, and transaction fees; all of
which should be avoided, if possible.

17. Card blocking occurs when money is “ear-marked” for a purpose even before it is actually
billed. For example, a customer uses a debit card to hold a hotel room. Although the
customer will not be charged for the room until arrival, the money in the account is blocked
so that it may not be spent before the hotel can collect. Blocking policies differ between
providers and can be especially cumbersome for customers with little extra balance in their
accounts.

PROBLEM AND ACTIVITY ANSWERS

1. Examples could include the following:

• Money saved for large upcoming expenses (e.g., car insurance).
• Money being held for upcoming tuition payments.
• Money being held for upcoming house down payment.
• Money being held for unexpected emergency expenses.
• Money being held for upcoming income tax payment.
• Money being held until more permanent investment decisions are made.

2. Assuming the historical $100,000 insurance limit Tony’s account balance of $75,000 is
completely covered, but Cynthia’s account is over the insurance limit by $4,000. She
should consider moving some of this money into the joint account or to another institution.
The joint account is also fully insured, because the $60,000 balance is well under the limit,
even if she were to move the $4,000 from her individual account.

Assuming the new, higher $250,000 insurance limit all account balances are under the limit
and are therefore fully insured by the FDIC.

3. The biggest benefit to mixing-and-matching is flexibility. However, by combining the best

account types and providers, you can also maximize returns and features, while minimizing
service charges and other fees. Also, by having money in various places, you are less likely
to jeopardize FDIC or NCUA coverage.

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 Cash or Liquid Asset Management 103

4. This example illustrates the cost associated with having to maintain a high minimum
balance in order to earn interest on checking. The forced balance is the amount of money
held in the account above what is necessary to pay monthly expenses.

$2,500 – $1,300 = $1,200 Forced balance

$1,200 x 3.25% = $39.00 Forgone interest
$2,500 x 1.00% = $25.00 Interest earned on checking account
$25.00 – $39.00 = -$14.00 Interest earned minus opportunity cost

The opportunity cost is the foregone interest that could have been earned at a higher rate on
the forced balance. In this example, $14.00 more could have been earned in an alternative
account.

5. 16.66% Annual Percentage Rate = ($400 / $9,600) x 4*

$10,000.00 Value at maturity
– $9,600.00 Discounted purchase price
$400.00 Total interest earned
* This is 4 because the example was a 3-month T-bill; therefore an investor could do this
four times per year. This rate also ignores the effects of compounding.

6. Use the following formula: After-tax return = taxable return (1 – marginal tax bracket)
• At the 15% marginal tax rate, the after-tax yield on the 6.65% corporate bond is 6.65%
x (1 – 0.15) = 6.65% x 0.85 = 5.65%. Thus, the corporate bond is a better alternative
than the 5.25% tax-free municipal bond, ignoring state taxes.
• At the 33% marginal tax rate, the after-tax return of the 6.65% corporate bond is 6.65%
x (1 – 0.33) = 6.65% x (0.67) = 4.46%. In this case, the 5.25% tax-free municipal bond
is a better alternative than the 6.65% corporate bond, ignoring state taxes.

7. Monetary returns are based on a constant $50,000 balance and annual compounding.

Rate $ Return
Nominal = 3.50% $1,750.00
After-tax: 3.5% x (1 – 0.28) = 2.52% $1,260.00
Real (estimation): 3.5% – 2.5% = 1.00% $500.00
Real (actual): [(1 + 0.035) / (1 + 0.025)] -1 = 0.98% $487.80
The following was not asked for but may provide an interesting teaching point.
Real, After-tax: [(1 + 0.0252)/(1 + 0.025)] -1 = 0.02% $9.76

The implication is that it is difficult to do any more than keep up with taxes and inflation
with liquid assets. Therefore, only the amount needed for financial emergencies and short-
term goals should be placed in assets with such a low risk-return ratio. Additional funds

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104 Chapter 5

should be invested elsewhere for a higher return. $50,000 is too much money to be earning
a low real rate of return, unless specific circumstances dictate otherwise.

8. The first tax rate at which the 2.78% municipal bond offers the better after-tax return is
33%.
After-tax = nominal x (1 – marginal tax bracket)
10% MTB 3.63% = 4.03% (1 – 0.10)
15% MTB 3.43% = 4.03% (1 – 0.15)
25% MTB 3.02% = 4.03% (1 – 0.25)
28% MTB 2.90% = 4.03% (1 – 0.28)
33% MTB 2.70% = 4.03% (1 – 0.33)

9. Student answers will vary but should include some of the following.
• Convenience factors
1. Efficiency—easy access if internet savvy, availability of specific services such as
online “bill-pay.”
2. Effectiveness—additional on-line services such as stock quotes, personal financial
management software
• Higher return—given the lack of “overhead” bank without physical location typically
can pay higher rates of return.

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 Cash or Liquid Asset Management 105

DISCUSSION CASE 1 ANSWERS

1. Examples could include the following:

For retirement
• Participate in employer 401(k) plan.
• Obtain employer match of 401(k) plan contribution.
• Sign up for U.S. savings bond purchase program.
For savings
• Direct deposit of paycheck into savings account.
• Authorize automated money market mutual fund or CD deposits.
For convenience
• Direct deposit of paycheck into checking or savings account.
• Join credit union savings plan.

2. Shu should consider the "3 Cs" when selecting an account:

• Cost—fees, minimum balances, per-check charges, etc.
• Convenience—location, availability of specific services, etc.
• Consideration—personal attention, services provided, etc.
It is advisable to compare the characteristics of at least three different accounts and select
the one that comes closest to her personal criteria for a liquid asset account.

3. Without an emergency fund, Shu might have to borrow funds to handle an emergency (e.g.,
use of credit cards) or liquidate a long-term investment at an inopportune time. The rule of
thumb is three to six months of expenses; therefore, Shu should keep $4,800 ($1,600 x 3) to
$9,600 ($1,600 x 6) in liquid assets not subject to fluctuations in the value of principal.

4. Wen's after-tax monthly income is $4,000, so an emergency fund of $12,000 to $24,000

maybe advisable. However, this is based on his earnings rather than his expenses so this
maybe erring to the high end – which may not be a bad thing given his employment history.

Instead, Todd has nearly 9 months of after-tax income earning a relatively low rate of
return. In the 25 percent marginal tax bracket, he'll net only 3.0 percent after taxes; and
after accounting for 3.0% inflation the return is basically zero. Wen should reinvest the
excess $11,000 in a higher-yielding asset designed to be compatible in maturity with one of
his financial goals.

5. For handling monthly expenses, Shu's options include a standard checking account, a bank
money market deposit account, and a money market mutual fund. All of these accounts have
advantages and disadvantages. MMDA’s have a limit of three checks per month, and
MMMF’s have minimum dollar requirements on check amounts, which makes neither of
these accounts very suitable for paying monthly bills. However, the basic checking account
does not generate a very high return. For short-term savings, typically liquidity is more
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important than return; therefore, the lowest cost, most flexible account would be best for her
monthly expense account.

Conversely, for the account Shu is using to save for her car, either of the money market
accounts would provide more return without sacrificing accessibility. Neither the minimum
check amount nor the monthly check writing limitation is of consequence given that she will
theoretically be making only one withdrawal – at the time of purchase. So choosing the
highest yielding account would be best.

6. Cashier’s checks can be preferable to certified checks because they are purchased from a
bank and drawn on the bank’s funds. Whereas a certified check is a check drawn on your
account and the institution “certifies” that the check is good by placing a hold on your
account for that specific check amount. There can be instances, though very rare, that the
institution, probably due to an account closure, may not honor a certified check.

DISCUSSION CASE 2 ANSWER

To balance his checkbook, Jarod should follow the steps in Figure 5.2, Worksheet for
Balancing Your Checking Account, as outlined below or Worksheet 8, Worksheet for
Balancing Your Checking Account.

Step 1: In reviewing the bank statement, Jarod noted three entries that were not recorded in his
checkbook register: $4.50 service charge; a $30 ATM withdrawal; and a $39 check card
purchase. Subtracting these from the $1,645.11 balance on his register resulted in an
adjusted balance of $1,571.61.

Step 2: The statement deposits and Jarod's checkbook register agree.

Step 3: No additional deposits were made since the date of the statement.

Step 4: Four checks were outstanding, for a total of $219.28, as listed below:
1079 $37.87
1083 $125.00
1085 $47.25
1086 $9.16

Step 5: Enter $1,797.39 from the statement.

Step 6: Enter 0.

Step 7: Add entries from steps 5 and 6, or $1,797.39.

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 Cash or Liquid Asset Management 107

Step 8: Enter (subtract) the total of the outstanding checks, or $219.28.

Step 9: Calculate the Adjusted Statement Balance of $1,578.11.

Compare this amount to the adjusted checkbook register balance from Step 1, or $1,571.61.
Because the numbers are out of balance – the checkbook is under by $6.50 – Jarod has other
problems which he can discover by completing the remaining Steps A, B, and C.

A) Since the account balanced last month, there should not be outstanding checks from the past
and all deposits have been included.

B) The final step is to check the math. Upon review Jarod made two common mistakes.
1. For check number 1076 he subtracted $59.75 rather than $69.75; resulting in a $10
overstatement.
2. For check number 1078 he transposed $320.20 for $302.20; resulting in an $18
understatement.
Making the appropriate correction for these mistakes, results in a July 29 balance of
$1,579.61; unfortunately, now Jarod is over by $1.50.

C) In one final check of the statement Jarod notices that he neglected to enter the $1.50 ATM
charge associated with his $50.00 withdrawal on June 29th. Making the final correction
leaves his checkbook with a balance of $1,578.11; in perfect agreement with his bank
statement.

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