Slide 1 CHAPTER 3 MANAGING CASH AND MARKETABLE SECURITIES NATURE OF CASH Cash is the life blood of any business and without it survival is very unlikely “What is the one thing your business needs th[.]
CHAPTER-3 MANAGING CASH AND MARKETABLE SECURITIES NATURE OF CASH Cash is the life-blood of any business and without it survival is very unlikely.… “What is the one thing your business needs the most in order to survive and grow…… if you don't have sufficient cash flow, your business could fail… People and organisations will not normally accept other than cash in settlement of their claims against the business If a business wants to employ people it must pay them in cash Cash to business is like fuel to a car CONT’D All purchases and payments are made through cash Cash by itself like other asset doesn’t produce goods and services Cash is sensitive to changes in working capital A decrease in account receivable will increase cash position The determination of cash flow for a particular period is dependent upon working capital Short term liquidity position of a firm is dependent on the amount of cash Loss due to shortage of cash can’t quantified easily Holding excess cash is a costly affairs ( it is an idle cash with opportunity cost) …Cash is often called a “nonearning asset MOTIVES OF HOLDING CASH Transaction motive: to meet routine cash requirements to finance transaction in the normal course of business Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc Precautionary motive (contingency needs): Cash inflows and outflows are unpredictable, with the degree of predictability varying among firms and industries Therefore, firms need to hold some cash in reserve for random, unforeseen fluctuations in inflows and outflows The more predictable the inflows and out flows of cash for a firm, the less cash that needs to be held for precautionary needs Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash balance Speculative motive (opportunity needs): is the need to hold cash in order to be able to take advantage of temporary opportunities like sudden decline in the price of raw material, attractive interest rates, and (in the case of international firms) favorable exchange rate fluctuations ADVANTAGES OF HOLDING ADEQUATE CASH It prevents insolvency or bankruptcy It helps in fostering good relationship with creditors and suppliers To take available trade discounts It leads to strong credit ratings It is useful to take advantage of favorable business opportunities, such as special offer from suppliers or the chance to acquire another firm To with the minimum strain, like strikes, fires or to meet unexpected expenditure competitors marketing campaigns, and to weather seasonal and cyclical downturns CASH MANAGEMENT The basic objectives of cash management are two, these are: To meet the cash disbursement need (payment schedule) To minimize funds committed to cash balance (Minimization of Idle cash) OPERATING CYCLE AND CASH CONVERSION CYCLE (CCC) The operating cycle is represented by the following sequences of events Purchase of material inputs Conversion of raw materials into w/p Conversion of w/p into finished goods Sale of finished goods, Account receivable Conversation of account receivable into cash Cash conversion cycle= Inventory conversion period + Receivables collection period – Payables deferral period CONT’D The cash conversion cycle can be shortened (1) by reducing the inventory conversion period by processing and selling goods more quickly, (2) by reducing the receivables collection period by speeding up collections, or (3) by lengthening the payables deferral period by slowing down the firm’s own payments CONT’D Cash turnover is the number of times firm’s cash is used during each year and the higher cash turnover, the less cash the firm requires Therefore, the firm should try to maximize the cash turnover but it must maintain a minimum amount of operating cash balances so that it doesn’t run out of cash Cash turn over = Number of days in a year Cash cycle High turnover is desirable since it reduces firm’s average cash balance and holding costs Minimum cash balance= Total annual outlay Cash turn over CONT’D Example: Over the past year, X company’s accounts receivable have averaged 80 day sales and inventories have averaged 60 days The company has paid its creditors, on average, 25 days after receiving the bill Production is evenly spread over the year and the company expects to spend birr 18 million during the year for materials and supplies Compute the following Cash cycle Cash turnover Minimum cash balance What is the birr cost of tying up the fund if the company’s opportunity cost is 20%? Solution a Cash cycle = 80 + (60-25) = 115 days b Cash turnover = 365/115 = 3.18 times c Minimum cash balance = 18,000,000 = birr 5,750,799 Birr cost = 5,750,799 x 0.2 = birr 1,150,160 CASH MANAGEMENT STRATEGIES A B Stretching (Extending) payments of accounts payable Efficient inventory production management Increasing the raw material turnover by using more efficient inventory control techniques Example: JIT- its reduces the idle investment Decreasing the production cycle through better production planning, scheduling and control techniques It will lead to an increase in WIP turn over Increasing finished goods turnover though better for casting of demand and better planning of production C Speedy collection of account receivable Credit terms- reducing the credit period Credit standards- increase the standards to reduce credit customers Collection policy- centralized and decentralized collection D Combined cash management strategies Each one of the above strategies if used results in saving Supposing if all the strategies are effected simultaneously then it is called combined cash management strategies ESTIMATING CASH BALANCES The key purpose of cash management is to hold optimal balance of cash that is just enough to meet the demand for cash Cash balance more than the optimum level will cost the firm’s profitability, whereas cash balance that is below the optimum level will result in poor liquidity Thus, the crux of cash management is to determine the level of cash which will provide sufficient liquidity without adversely affecting profitability QUANTITATIVE MODELS OF ESTIMATING CASH BALANCE Two quantitative models that management can use to determine the optimum cash balances are the Baumol model and the Miller-Orr model Baumol Model William J.Baumol for the first time adopted the inventory economic order quantity model for cash management in 1952 The model is popularly known as the Baumol’s model The Baumol model is a simple approach that provides for cost-efficient transactional cash balances by determining optimal cash conversion quantity, that is, the optimal amount of cash that should be transferred from marketable securities to cash each time a conversion is made BAUMOL MODEL ASSUMPTIONS There are certain assumptions that are made in the model They are as follows: The firm is able to forecast its cash requirements with certainty and receive a specific amount at regular intervals The firm’s cash payments occur uniformly over a period of time, i.e., a steady rate of cash outflows The opportunity cost of holding cash is known and does not change over time The firm will incur the same transactional cost whenever it converts securities to cash CONT’D Opportunity Cost: is the interest earnings per birr given up during a specified time period as a result of holding funds in a non-interest earning cash account rather than having them invested in interest earning marketable securities This cost is the cost of holding cash instead of investing the cash in marketable securities Thus, the firm incurs a holding cost for maintaining the cash balance It is known as opportunity cost, the return inevitable on the marketable securities HoldingCost=k(C*/2) Where; k = the opportunity (in decimal form) C *= the optimal amount of conversion (optimum cash balance) C*/2 = the average cash balance Transaction Cost (Conversion Cost): whenever the firm converts its marketable securities to cash, it incurs a cost known as transaction cost This includes the fixed cost of placing and receiving an order for cash in the amount of the optimal cash balance (C*) Total number of Total Funds Required (T) transaction Optimal Cash Balance(C*) The assumption here is that the cost per transaction is constant If the cost per transaction is c, then the total transaction cost will be: Transaction cost = Cost per transaction x Total # of transaction = c x (T/C*) CONT’D The optimal cash balance (C*) is the balance that will minimize the total cost of managing cash Total cost: is the sum of the total conversion and total opportunity costs Total cost = Holding cost + Transaction cost Total cost= k (C */2) + c (T/C*) Optimum Level of Cash Balance As the demand for cash, ‘C’ increases, the holding cost will also increase and the transaction cost will reduce because of a decline in the number of transactions Hence, it can be said that there is a relationship b/n the holding cost and the transaction cost The optimum cash balance, C* is obtained when the total cost is minimum When we solve the total cost equation shown above to determine the level of C* where total cost is minimum, we get the following equation for C*: C* = x c x T Where: C* = the optimal amount of conversion k T = the total cash needed during the year c = cost per conversion k = the opportunity cost of holding cash EXAMPLE: FOR APPLYING THE BUAMOL MODEL The management of Hake Sport, a small distributor of sporting goods, anticipates Br.1,500,000 cash outlays (demand) during the coming year A recent study indicates that it costs Br 30 to convert marketable securities to cash The marketable securities portfolio currently earns an 8% annual rate or return Required: Compute a) The optimum cash conversion balance (C*) b) The number of conversions c) The average cash balance d) The total cost THE MILLER-ORR MODEL The Miller-Orr (MO) model is considered by many as more realistic model for cash management as compared to Baumol’s model since it allows the fluctuation in cash balance from time to time The model was developed by Merton Miller and Daniel Orr in the early 1960S, hence the name Miller-Orr model The MO model overcomes Baumol’s shortcoming and allows for daily cash flow variation CONT’D MILLER ORR The firm sets the lower control limit as per its requirement of maintaining minimum cash balance The difference between the upper limit and the lower limit depends on the following factors: The transaction cost (c) The interest rate, (k) The standard deviation () of net cash flows The formula for determining the distance between upper and lower control limits (called Z) is as follows: Z = x Transaction Cost x variance of daily Cash flow x daily opportunity cost (in decimal form) Z = x c x 2 4xk 1/3 1/3 CONT’D 1) Z will be larger if transaction cost is higher or cash flows show greater fluctuation 2) The gap b/n the two limits will come closer as the interest rate increases, i.e., Z is inversely related to the interest rate Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z This is the optimum (target) cash balance Average Cash Balance = Lower Limit + 4/3Z EXAMPLE: ON APPLYING THE MILLER ORR MODEL Continuing with the prior example, the management of Hake Sport sets the minimum cash balance of Br.1,000 The cost that converts marketable securities (MSS) to cash is Br.30; the firm’s MSS portfolio earns an 8% annual return The variance of Hake Sport’s daily net cash flows is estimated to be Br 27,000 Required: Compute a) the distance b/n the Upper and the Lower Limits (Z) b) the Upper limit c) average cash balance and the target cash balance