CHAPTER 20

CASH AND LIQUIDITY MANAGEMENT

20.1

REASONS FOR HOLDING CASH

The Speculative and Precautionary Moties The speculative motive is need to hold cash in order to be able to take advantage of additional investment opportunities, such as bargain purchases. The precautionary is the need to hold cash as a safety margin to act as a financial reserve.

The Transaction Motive Transaction motive is the need to hold cash to satisfy normal disbursement and collection activities associated with a firms ongoing operations.

Compensating Balances Compensating balances are another reason to hold cash. A minimum compensating balances requirement may impose a lower limit on the level of cash a firm holds.

Costs of Holding Cash Activities such as selling marketable securities and borrowing involve varios costs. To determine the appropriate cash balance, the firm must weigh the benefits of holding cash against these cost.

Cash Management versus Liquidity Management The distinction is a source of confusion because the word cash is used in practice in two different ways. The distinction between liquidity management and cash management is staraigtforward. Liquidity management concern the optimal quantity of liquid assets a firm should have on hand, and it is one particular aspect of the current asset management policies. Cash management is much more closely related to optimizing mechanisms for collecting and disbursing cash.

20.2

UNDERSTANDING FLOAT

The cash balance that a firm shows on its books is called the firms book, or ledger balance. The balance shown in its bank account as available to spend is called its available, or collected balance. The difference between the available balance and ledger balance is called the float.

Disbursement Float Checks written by a firm generate disbursement float, causing a decrease in the firms book balance but no change in its available balance.

Collection Float and Net Float Checks received by the firm create collection float. Collection float increase book balances but does not immediately change available balances.

Float Management Float management involves controlling the collection and disbursement of cash. Total collection or disbursement times can be broken down into three parts : 1. Mailing time is the part of the collection and disbursement process during which checks are trapped in the postal system. 2. Processing delay is the time it takes the receiver of a check to process the payment and deposit it in bank for collection. 3. Availiability delay refers to the time required to clear a check through the banking system.

Measuring Float The size of the float depends on both the dollars and the time delay involved. Costs of the Float The basic cost of collection float to the firm is simply opportunity cost of not being able to use the cash. At a minimum, the firm could earn interest on the cash if it were available for investing.

Ethical and Legal Questions The cash manager must work with collected bank cash balances and not the firms book balance. If this is not done, a cash manager could be drowing on uncollected cash as a source of funds for short-term investing. Electronic Data Interchange : The End of Float ? Electronis Data Interchange is a general term tha refers to the growing practice of direct, electronic information exchange between all types of business.

20.3

CASH COLLECTION AND CONCENTRATION

Component of Collection Time The amount of time that cash spends in each part of the cash collection process depends on where the firms customers and banks are located and how efficient the firm is in collecting cash. Cash Collection The simplest cash would be a business such as a restaurant will pay with cash, check, or credit card at the point of sale, so there is no problem with mailing delay. Lockboxes Special post office boxes set up to intercept and speed up accounts receivable payment. Cash Concentration The practice of and proced ures for moving cash from multiple bamks into the firms main accounts.

20.4

MANAGING CASH DISBURSEMENT

Increasing Disbursement Float Tactics for maximing disbursement floats are debatable on both ethical and economic grounds. In such cases, increasing mailing time will be of no benefit if the receipient dates payment based on the data received as opposed to the postmark date.

Controlling Disbursement A firm will still wish to tie up as little cash as possible in disbursement. Firms have therefore developed system for efficiently managing the disbursement process. Zero-Balance Accounts With zero-balance account system, the firm, in cooperation with its bank, maintain a master account and a set of subaccounts.

20.5

INVESTING IDLE CASH

Temporary Cash Surpluses Firms have temporary cash surpluses for various reasons. Two of the most important are the financing of seasonal or cyclical activities oh the firm and the financing of planned or possible expenditures. Seasonal or Cyclical Activities Some firms have a predictable cash flow pattern. They have surplus cash flows during part of the year and deficit cash flows the rest of year. 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. Characteristics of Short-Term Securities Given that a firm some temporarily idle cash, there are a variety of short-term securities available for investing. Maturity We called this type of risk interest rate risk. Firms often limit their investment in marketable securities to those maturating to avoid of looses in value from changing interest rate. Default Risk Default risk refers to the proability that interest and principal will not be paid in the promised amounts on the due dates.

Marketability Marketability refers to how easy its to convert an asset to cash, so marketability and liquidity mean much the same thing. Taxes Interest earned on money market securities that are not some kind of government obligation is taxable at the local, state, and federal levels.

20A The BAT Model

DETERMINING THE TARGET CASH BALANCE

The Baumol-Allais-Tobin (BAT) model is a classic means of analyzing our cash management problem. This model can be used to actually establish the target cash balance. It is a straightforward model and very useful for illustarating yhe factors in cash management and more generally current asset management. The Opportunity Costs To determine the Opportunity costs of holding cash. Opportunity costs = (C/2) X R The Trading Costs To determine the opportunity costs for the year. Trading costs = (T/C) X F The Total Cost Total cost = Opportunity costs + Trading costs = (C/2) X R + (T/C) X F Conclusion The BAT model is possibly the simplest and most stripped-doqn sensible model for determining the optimal cash position.

The Miller-Orr Model : A Model General Approch This model concentrate on the cxash balance, but in contrast to the situation witn the Bat model, that this balance fluctuates up and down randomly and that the average chane is zero.

The Basic Idea

It operates in terms of an upper limit to the amount of cash (U*) and a lower limit (L), and the target cash balance (C*). The firms allows its cash balance to wander around between the lower and upper limits.

Using the Model To get started, management sets the lower limit (L). This limit esantially defines a safety stock, so where its set depends on how much risk of a cash shortfall the willing to tolerate. Implications of The BAT and Miller-Orr Models In both casea, all other things being equal : 1. The greater the interest rate, the lower is the target cash balance. 2. The greater the order cost, the higher is the target balance. These implications are both fairly obvious. The advantages od The Miller-Orr model is that it improve our understanding of the problem of cash management by considering the effect of uncertainty as measured by the variation in net cash inflows. Other Factors Influencing the Target Cash Balance Borrowing introduces additional considerations to cash management : 1. Borrowing is likely to be more expensive than selling marketable securities because the interest rate is likely to be higher. 2. The need to borrow will depend on mangements desire to hold low cash balance.