Trang Nguyen

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Cash and liquidity

management
Cash and liquidity management

• Reasons for holding cash

• Determining the target cash balance
• Understanding Float
• Cash collection and concentration
• Managing cash disbursements
• Investing Idle cash
Why do companies need to hold cash?
1. Reasons for holding cash

• Speculative motive: is the need to hold cash 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
• Precautionary motive: is the need for a safety supply to act as a financial reserve
• Transaction motive: the need to have cash on hand to pay bills.
Costs of holding cash

• When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost
• The opportunity cost of excess cash is the interest income that could be earned in the next
best use, such as investment in marketable securities.
• A cash balance must be maintained to provide the liquidity necessary for transaction needs—
paying bills
Cash management versus Liquidity management

• Liquidity management concerns the optimal quantity of liquid assets a firm should have on
hand
• Cash management is much more closely related to optimizing mechanisms for collecting and
disbursing cash
2. 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
+ If the firm has a flexible working capital policy ???
+ If the firm has a restrictive working capital policy ???
The basic idea
• The greater the opportunity cost, the higher is the target cash balance.
• The greater the trading cost, the lower is the target balance.
Indicate the likely impact of each of the following on a company’s target cash balance. Use the
letter I to denote an increase and D to denote a decrease. Briefly explain your reasoning in each
case:

a. Commissions charged by brokers decrease.

b. Interest rates paid on money market securities rise.
c. The compensating balance requirement of a bank is raised
d. The firm’s credit rating improves.
e. The cost of borrowing increases.
f. Direct fees for banking services are established.
Other Factors Influencing the Target Cash Balance

Cash management
• Borrowing is likely to be more expensive than selling marketable securities because the in-
terest rate is likely to be higher
• The need to borrow depends on management’s desire to hold low cash balances. A firm is
more likely to have to borrow to cover an unexpected cash outflow the greater its cash flow
variability and the lower its investment in marketable securities.
For large firms, the trading costs of buying and selling securities are very small when compared
to the opportunity costs of holding cash
3. Understanding Float

• The cash balance that a firm shows on its books is called the firm’s book or ledger balance
• The balance shown in its bank account is called its available or collected balance
ÞThe difference between the available balance and the ledger balance is called the float
Ø Disbursement Float
Ø Collection Float and Net Float
Disbursement Float

• Cheques written by a firm generate disbursement float

• DF makes a decrease in its book balance
• DF makes no change in its available balance
Float = Firm’s available balance - Firm’s book balance
Disbursement Float

Example: Suppose General Mechanics Inc. (GMI) currently has $100,000 on deposit with its
bank. On June 8, it buys some raw materials and puts a cheque in the mail for $100,000.
GMI’s bank, however, does not find out about this cheque until it is presented to GMI’s bank
for payment on, say, June 14.
What is your disbursement float?
Collection Float and net Float

• Cheques received by the firm create collection float

• CF increases book balances
• CF does not immediately change available balances
• The net float at a point in time is simply the overall difference between the firm’s available balance
and its book balance
Net Float = Collections Float + Disbursement Float

+ If the net float is positive => the bank thinks the firm has more cash than it really does
+ If the net float is negative => Firms actually have more cash than the bank thinks firms do, but
firms can’t use it
Collection Float and net Float

Example: suppose GMI receives a cheque from a customer for $100,000 on October 8. As
before, the company has $100,000 deposited at its bank. This occurs on, say, October 9, the
next day.
What are your collection, and net floats?
Example: Suppose you have $5,000 on deposit. You write and mail a cheque for $1,000. You
receive a cheque for $2,000 and put it in your wallet to deposit the next time you use a bank
ma- chine. What are your disbursement, collection, and net floats?
Float management
• Float management involves controlling the collection and disbursement of cash.
Cash collection Cash disbursement
To speed up collections To control payments
To reduce the lag between the time To minimize the firm’s costs
customers pay their bills and the time associated with making payments
the cheques are collected

• Float can be broken down into three parts:

+ Mail float is part of the collection and disbursement process where cheques are trapped in the postal system.
+ Processing float is the time it takes the receiver of a cheque to process the payment and deposit it in a bank.
+ Availability float refers to the time required to clear a cheque through the banking system.
Measuring Float

• The size of the float depends on both the dollars and time delay involved
Example: suppose you receive a cheque for $500 from another province each month. It takes
five days in the mail to reach you and one day for you to get over to the bank. The bank gives
you immediate availability.
ÞThe total delay is ??? days.
Þ What is your average daily float?
Cost of the Float

• The basic cost to the firm of collection float is the opportunity cost from not being able to use
the cash.
• At a minimum, the firm could earn interest on the cash if it were available for investing.
Cost of the Float

Example: Suppose the Lambo Corporation has average daily receipts of $1,000 and a weighted
average delay of three days.
a. Lambo could eliminate the float entirely. What would be the benefit? If it costs $2,000 to
eliminate the float, what is the NPV of doing it?
b. Instead of eliminating the float, suppose Lambo can reduce it to one day. What is the
maximum Lambo should be willing to pay for this?
SUMMARY OF FLOAT MEASURES

Float = Firm’s available balance - Firm’s book balance

Average daily float = Total float/Total days
Average daily receipts = Total receipts/Total days
Average daily float = Average daily receipts × Weighted average delay