Chapter Outline

1. Tracing Cash and Net Working Capital

Chapter 5 2. The Operating Cycle and Cash Cycle

3. Understanding Float
CASH MANAGEMENT 4. Managing Cash Collection and Disbursement
5. Investing Idle Cash
Dr. Nguyen Quynh Tho
6. The BAT and Miller-Orr Model

Balance Sheet Model of the Firm

Current
Liabilities
Current
Part 1. Assets Net Working
Capital
Long-Term
Debt

Tracing Cash How much short-

and Net Working Capital
Fixed Assets
term cash flow does
1. Tangible a company need to
Shareholders’
pay its bills?
2. Intangible Equity

Tracing Cash and Net Working Capital Defining Cash in Terms of Other Elements

• Current Assets are cash and other assets that are expected to be Long-
Net Working Fixed
converted to cash within the year. + = Term + Equity
Capital Assets
Ø Cash Debt
Ø Marketable securities
Ø Accounts receivable Other
Net Working Current
Ø Inventory = Cash + Current –
Capital Liabilities
• Current Liabilities are obligations that are expected to require cash Assets
payment within the year.
Ø Accounts payable Long- Net Working
Fixed
Ø Accrued wages Cash = Term + Equity – Capital –
Assets
Ø Taxes Debt (excluding cash)
 Defining Cash in Terms of Other Elements Reasons for Holding Cash

● Speculative motive – hold cash to take advantage of unexpected

Long- Net Working opportunities
Fixed
Cash = Term + Equity – Capital –
Assets
Debt (excluding cash) ● Precautionary motive – hold cash in case of emergencies

● Transaction motive – hold cash to pay the day-to-day bills

●An increase in long-term debt and/or equity leads to an increase in cash—as
● Trade-off between opportunity cost of holding cash relative to the
does a decrease in fixed assets or a decrease in the non-cash components of
net working capital. transaction cost of converting marketable securities to cash for
transactions

The Operating Cycle and the Cash Cycle

Raw material
Cash
purchased Finished goods sold
received
Part 2. Order Stock
Placed Arrive

The Operating Cycle and s

Inventory period Accounts receivable period

the Cash Cycle Accounts payable period

Time

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle

The Operating Cycle and the Cash Cycle The Operating Cycle and the Cash Cycle

● Inventory:
Accounts
○ Beginning = 200,000 Ending = 300,000
Cash cycle = Operating cycle – payable
period Example ● Accounts Receivable:
○ Beginning = 160,000 Ending = 200,000

●In practice, the inventory period, the accounts receivable ● Accounts Payable:
○ Beginning = 75,000 Ending = 100,000
period, and the accounts payable period are measured by
days in inventory, days in receivables, and days in payables, ● Net sales = 1,150,000

respectively. ● Cost of Goods sold = 820,000

 The Operating Cycle and the Cash Cycle The Operating Cycle and the Cash Cycle

● Inventory period
● Payables Period
○ Average inventory = (200,000+300,000)/2 = 250,000
○ Average payables = (75,000+100,000)/2 = 87,500
○ Inventory turnover = 820,000 / 250,000 = 3.28 times
Example Example ○ Payables turnover = 820,000 / 87,500 = 9.37 times
○ Inventory period = 365 / 3.28 = 111.3 days
○ Payables period = 365 / 9.37 = 38.9 days
● Receivables period
● Cash Cycle = 168.4 – 38.9 = 129.5 days
○ Average receivables = (160,000+200,000)/2 = 180,000
● We have to finance our inventory for 129.5 days.
○ Receivables turnover = 1,150,000 / 180,000 = 6.39 times

○ Receivables period = 365 / 6.39 = 57.1 days ● If we want to reduce our financing needs, we need
to look carefully at our receivables and inventory
● Operating cycle = 111.3 + 57.1 = 168.4 days periods – they both seem excessive.

Cash Budgeting

●A cash budget is a primary tool of short-run financial planning.

●The idea is simple: Record the estimates of cash receipts and
Part 3. disbursements.
●Cash Receipts
Cash Budgeting ○Arise from sales, but we need to estimate when we actually collect
●Cash Outflow
○Payments of Accounts Payable
○Wages, Taxes, and other Expenses
○Capital Expenditures
○Long-Term Financial Planning

Cash Budgeting: Example Cash Budgeting: Example

● Pet Treats Inc. specializes in gourmet pet treats and receives all income from sales
● ACP = 30 days, this implies that 2/3 of sales are collected in the quarter made,
● Sales estimates (in millions)
and the remaining 1/3 are collected the following quarter.
○ Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
● Accounts receivable ● Beginning receivables of $250 will be collected in the first quarter.
○ Beginning receivables = $250
○ Average collection period = 30 days
● Accounts payable Q1 Q2 Q3 Q4
○ Purchases = 50% of next quarter’s sales
○ Beginning payables = 125
Beginning Receivables 250 167 200 217
○ Accounts payable period is 45 days Sales 500 600 650 800
● Other expenses
Cash Collections 583 567 633 750
○ Wages, taxes and other expense are 30% of sales
○ Interest and dividend payments are $50 Ending Receivables 167 200 217 267
○ A major capital expenditure of $200 is expected in the second quarter
● The initial cash balance is $80 and the company maintains a minimum balance of $50
 Cash Budgeting: Example Cash Budgeting: Example

● Payables period is 45 days, so half of the purchases will be paid for

each quarter, and the remaining will be paid the following quarter.
Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
● Beginning payables = $125 Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Q1 Q2 Q3 Q4 Beginning Cash Balance 80 188 12 38
Payment of accounts 275 313 362 338 Net cash inflow 108 -176 26 122
Wages, taxes and other expenses 150 180 195 240 Ending cash balance 188 12 38 160
Capital expenditures 200 Minimum cash balance -50 -50 -50 -50
Interest and dividend payments 50 50 50 50 Cumulative surplus (deficit) 138 -39 -12 110
Total cash disbursements 475 743 607 628

Managing Cash Collection

Payment Payment Payment Cash

Mailed Received Deposited Available
Part 4. Mailing Time Processing Delay Availability Delay
Managing Cash Collection and Collection Delay

Cash Disbursements One of the goals of float management is to try to reduce the
collection delay. There are several techniques that can reduce
various parts of the delay.

Example: Accelerating Collections – Part I Example: Accelerating Collections – Part II

●Your company does business nationally, and currently, all checks are sent to ●Benefits
the headquarters in Tampa, FL. You are considering a lock-box system that
will have checks processed in Phoenix, St. Louis and Philadelphia. The Tampa ○Average daily collections = 3(5,000)(500) = 7,500,000
office will continue to process the checks it receives in house.
○Increased bank balance = 2(7,500,000) = 15,000,000
○Collection time will be reduced by 2 days on average
●Costs
○Daily interest rate on T-bills = .01%
○Daily cost = .1(15,000) + 3*10 = 1,530
○Average number of daily payments to each lockbox is 5,000
○Present value of daily cost = 1,530/.0001 = 15,300,000
○Average size of payment is $500
●NPV = 15,000,000 – 15,300,000 = -300,000
○The processing fee is $.10 per check plus $10 to wire funds to a centralized
bank at the end of each day. ●The company should not accept this lock-box proposal
 Managing Cash Disbursements

●Slowing down payments can increase disbursement float – but

it may not be ethical or optimal to do this

●Controlling disbursements Part 5.

○Zero-balance account
Investing Idle Cash
○Controlled disbursement account

Investing Cash Figure 27.6

●Money market – financial instruments with an original

maturity of one year or less

●Temporary Cash Surpluses

○Seasonal or cyclical activities – buy marketable securities with
seasonal surpluses, convert securities back to cash when deficits
occur

○Planned or possible expenditures – accumulate marketable

securities in anticipation of upcoming expenses

Characteristics of Short-Term Securities

●Maturity – firms often limit the maturity of short-term investments to

90 days to avoid loss of principal due to changing interest rates

●Default risk – avoid investing in marketable securities with Part 6.

significant default risk
Optimal Cash Balance
●Marketability – ease of converting to cash

●Taxability – consider different tax characteristics when making a

decision
 Costs of Holding Cash The Baumol-Allais-Tobin (BAT) Model

F = The fixed cost of selling securities to raise cash

Costs in dollars of
holding cash Trading costs increase when the firm must sell T = The total amount of new cash needed
securities to meet cash needs.
R = The opportunity cost of holding cash, i.e., the interest rate.
Total cost of holding cash If we start with $C, spend at a constant rate each
period and replace our cash with $C when we run out
Opportunity Costs of cash, our average cash balance will be C
C –
2
The investment income foregone when
holding cash. C
–
2
The opportunity cost of holding C/2 cash is
Trading costs C
– ×R
C* 2
Size of cash balance 1 2 3 Time

The BAT Model The BAT Model

C T
Total cost = ´R+ ´F
As we transfer $C each 2 C
C
period we incur a trading Opportunity Costs ´R
2
C cost of F.

If we need $T in total
C
–
2
over the planning period
T Trading costs
T
´F
we will pay $F times. –
C
C

C* Size of cash balance

1 2 3 Time
T
The trading cost is –
C
×F
C* =
2T
´F
R

The BAT Model The BAT Model: Example

The optimal cash balance is found where the opportunity costs

equals the trading costs.
Hermes Co. has cash outflows of $500 per day, the
Opportunity Costs = Trading Costs
interest rate is 10% and the fixed transfer cost is $25.
C T
´R = ´F
2 C
What is optimal cash balance for the company?
Multiply both sides by C

C2 T´F
´R =T ´F C2 = 2´
2 R
2TF
C* =
R
 The Miller-Orr Model The Miller-Orr Model Math

●The firm allows its cash balance to wander randomly between upper and lower
control limits. ●Given L, which is set by the firm, the Miller-Orr model
solves for C* and U
$ When the cash balance reaches the upper control limit U, cash is invested
elsewhere to get us to the target cash balance C. 3Fs 2 U * = 3C * - 2L
U C* = 3 +L
4R
When the cash balance
reaches the lower control limit,
L, investments are sold to raise where s2 is the variance of net daily cash flows.
cash to get us up to the target
cash balance. • The average cash balance in the Miller-Orr model is:
C
4C * - L
L Average cash balance =
3
Time

Implications of the Miller-Orr Model Implications of the Miller-Orr Model

● To use the Miller-Orr model, the manager must do four things:

● The model clarifies the issues of cash management:
1. Set the lower control limit for the cash balance.
○ The optimal cash position, C*, is positively related to trading
2. Estimate the standard deviation of daily cash flows. costs, F, and negatively related to the interest rate R.

3. Determine the interest rate. ○ C* and the average cash balance are positively related to the
variability of cash flows.
4. Estimate the trading costs of buying and selling securities.

Other Factors Influencing the Target Cash Balance QUICK QUIZ

● Borrowing
●What are the major reasons for holding cash?
○Borrowing is likely to be more expensive than selling marketable ●What is the difference between disbursement float and collection
securities.
float?
○The need to borrow will depend on management’s desire to hold low ●How does a lockbox system work?
cash balances.
●What are the major characteristics of short-term securities?