SESSION 15 CASH MANAGEMENT

1501
OVERVIEW
Objective
To understand the importance of cash flow and methods of controlling cash flows, the
theoretical models relating to optimal cash balances and the importance of treasury
management.




TREASURY
MANAGEMENT
OPTIMAL CASH
BALANCES
BORROWING IN
THE SHORT-TERM
Advantages of centralised treasury
management
The role of the treasurer
Cash flow budgeting
Sensitivity analysis in cash budgeting
Sources
INVESTING IN
THE SHORT-TERM
Why do surplus funds arise?
Investing surplus funds
factors to consider
Short-term investments
EOQ (Baumol) model
Miller-Orr model
CASH
MANAGEMENT
Reasons for holding cash
Cash and profits



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1 CASH MANAGEMENT
1.1 Reasons for holding cash
Transactions motive to provide sufficient liquidity to meet current day-to-day
financial obligations, e.g. payroll, the purchase of raw materials, etc.
Precautionary motive a cash reserve to give a cushion against unplanned expenditure,
rather like buffer/safety level of inventory. This reserve may be held in the form of
cash equivalents - short-term, low risk, highly liquid investments e.g. treasury bills.
Speculative motive to quickly take advantage of investment opportunities that may
arise e.g. some firms build a war chest of cash ready to use if a suitable takeover target
appears.
However it is important that a firm does not hold excessive levels of cash as this leads to
inefficiency. Cash balances belong to the shareholders who are expecting to receive
significant return on their investment in the firm.
Any long-term surplus of cash should therefore be either reinvested into positive NPV
projects or returned to shareholders via:
Dividends possibly as a special dividend, or
Share buy-back programme
1.2 Cash and profits
Profits are accounted for on an accruals basis and a company must be profitable to continue
in existence. However, profitability is not enough; companies must also have enough cash
flow available to meet all their day to day payments and longer-term commitments in order
to survive.
2 TREASURY MANAGEMENT
Definition

The efficient management of liquidity and risk in a business including the
management of funds (generated from internal and external sources),
currencies and cash flow.


As companies and financial markets have become larger, more sophisticated and
increasingly international, there has been a trend towards the establishment of separate
treasury departments where the control of cash is centralised in order to ensure its efficient
use.
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2.1 Advantages of centralised treasury management
These include:
Management by specialised staff;
Economies of scale e.g. less staff required in total ;
Pooling - netting cash deficits against surpluses in order to save interest expense.
Increased negotiating power with banks;
More efficient foreign exchange risk management - the treasury department at head
office can find the groups net position on each currency and then consider an external
hedge on this balance.
Within a treasury department of a large company there may still be a degree of
decentralisation in order to ensure that the decisions taken are appropriate to local
circumstances.
2.2 The role of the treasurer
To have the right amount of cash available at the right time the treasurer will be involved in:
accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;
planning short-term borrowing when necessary;
planning investments of surpluses when necessary;
cost efficient cash transmission;
dealing with foreign currency issues;
optimising banking arrangements;
planning major finance-raising exercises;
accounts receivable/accounts payable policies.

In addition, the treasurer is often involved in risk assessment and insurance.
2.3 Cash flow budgeting
A major task of the treasurer is cash flow budgeting. A simple pro-forma is given below:
Forecast:

Sales volume;
Revenue;
Costs;
One-off expenses (e.g. capital expenditure).
Typical format
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Q1 Q2 Q3 Q4 Total
Cash inflows $ $ $ $ $
Cash sales x x x x x
Cash from receivables x x x x x
Fixed asset disposals x x x x x
Share/debt issues x x x x x

___

___

___

___

___

Total inflow x x x x x

___

___

___

___

___

Cash outflows
Materials x x x x x
Labour x x x x x
Variable overhead x x x x x
Fixed overhead x x x x x
Dividends x x
Capital expenditure/leases x x
Interest/principal on debt x x x x x

___

___

___

___

___

x x x x x

___

___

___

___

___


Net cash flow x x x x x
Opening balance x x x x x

___

___

___

___

___

Closing balance x x x x x

___

___

___

___

___


2.4 Sensitivity analysis in cash budgeting
Sensitivity analysis answers the question What if? and can be used to deal with
uncertainty in cash budgeting.
The effect on net cash flows per month or quarter could be examined in the following
ways:
Considering changes in payment patterns by credit customers. Best-case and
worst- case scenarios should be examined.
Allowing for changes in the timing of other receipts, e.g. sale of fixed assets, rights
issues, debt issues, etc.
Considering changes in materials costs. If prices are uncertain, a worst-case
scenario should be examined.
Allowing for changes in other costs (e.g. labour, overheads) or timings of outflows
(e.g. fixed overhead payments, dividends, capital expenditure).
Considering changes in interest rates where borrowings are at variable rates. A
worst- case scenario should be forecast.
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3 BORROWING IN THE SHORT-TERM
Having completed a cash flow forecast the treasurer may identify a requirement to borrow
funds in the short term.
3.1 Sources of short-term borrowing
Debt factoring and invoice discounting;
Bank overdraft - however:
technically repayable on demand (although the bank may offer a revolving line of
credit);
normally carries a flat charge for the facility and high variable interest rate on the
balance.
Short-term loans:
may require security
can have fixed or variable rates of interest.
4 INVESTING IN THE SHORT-TERM
Alternatively a treasurer may discover that the company has a cash surplus for a short-term
period.
4.1 Why do surplus funds arise?
Over funding proceeds which are not yet fully required may have already been
received from a share/debt issue;
Disposal of surplus assets or divisions;
Operating surpluses.
4.2 Investing surplus funds factors to consider
Amount of funds available.
Liquidity how quickly can the investment be converted back into cash?
Risk the treasurer should not gamble with the shareholders funds
Return on the proposed investment obviously this will be limited by the requirement
to select low risk investments.
The general rule is to select short-term, low risk, highly liquid investments e.g. treasury bills.
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4.3 Short-term investments
Money market deposits i.e.-bank deposits. There may be a notice period for
withdrawals and therefore should only be used if there is high certainty of cash flows.
Certificate of deposit - negotiable deposits issued by banks and building societies,
maturities from 28 days to 5 years. The holder can sell the certificate before its maturity
date, hence more liquid than money market deposits but lower returns.
Treasury bills 2, 3, and 6 month UK government debt, very low risk and very liquid,
but even lower returns.
Gilt-edged government securities (gilts) the long term version of Treasury Bills with
maturities usually greater than 5 years. It is not recommended that short-term cash
surpluses are invested in newly issued gilts as their market prices are very sensitive to
interest rate changes. It would be more sensible to invest in gilts which are close to
maturity
Other government bonds for example UK local authority bonds, rates tied to money
markets, good liquidity.
Certificates of tax deposit deposits with UK Inland Revenue that may be surrendered
for cash or used in settlement of tax liabilities.
Commercial paper short term (7 days - 3 months) unsecured debts issued by high
quality companies, good liquidity
Corporate bonds - longer maturity fixed interest securities issued by the corporate
sector. Liquidity can be poor and risk higher than on government bonds or commercial
paper.
Equities investing short term cash surpluses on the stock market is not recommended
as high risk.
Non-sterling instruments - most of the above have non-sterling counterparts, e.g. US
Treasury bills, etc; beware exchange risk.
Commentary

Most businesses will be looking for a variety of investments in order to minimise the
risks involved, and also to ensure that some cash is available at short notice and that
some is invested longer term to obtain higher interest rates.


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5 OPTIMAL CASH BALANCES
Is there an optimal cash balance?
Two theoretical models will now be considered.
5.1 EOQ (Baumol) model
5.1.1 Assumptions
This model applies the EOQ model to cash. It assumes that that cash requirements are
funded by the sale of parcels of securities e.g. Treasury Bills.
The model calculates the optimal size for the parcel of securities. This is known as the
economic transfer.
5.1.2 Formula
s = cash needs for the period
f = transaction costs (brokerage, commission etc) of
selling a parcel of securities
h = Opportunity cost of holding cash (interest forgone
on securities)

Economic transfer =
h
2fs

5.1.3 Weaknesses
Uncertainty - demand for cash is not constant.
The model assumes that the business is constantly using cash and must finance this by
selling investments. However any worthwhile business must at some point generate cash
rather than burn it.

Illustration 1

A firm has large deposits which currently attract interest of 15%.
It has cash needs of $300,000 in the next year.
Transaction costs are $120.
Required:
What is the economic transfer and the average cash balance?

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Solution
s = 300,000
f = 120
h = 0.15
Economic transfer
=
0.15
300,000 120 2
= $21,909
Average balance
=
2
$21,909
= $10,954

5.2 Miller-Orr model

Cash
balance
Upper limit
Return point
Lower limit
Time
convert investments
back into cash
make investments

Lower limit - represents the safety level of cash and is set by management. If cash falls
to this level then sell short-term investments to return the cash balance to the Return
Point.
Upper limit - the maximum level of cash to hold. Once the cash balance reaches the
upper limit, short-term investments should be bought in order to bring the cash balance
back down to the Return Point.
Return Point the level to which cash balances should be brought if they reach the
upper or lower limit.
The model is particularly useful when cash flows are uncertain.
The return point is set to minimise the sum of transaction costs and lost interest on
investments
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The following formulae are provided in the examination :
Return point = Lower limit + ( spread)
Spread =
3
1
rate interest
flows cash of variance cost n transactio
3
4
3

Where:
Spread = the difference between the upper limit and lower limit
Transaction costs = the fixed cost of buying or selling marketable securities
Variance = variance of the net daily cash flows
Interest rate = daily interest rate on marketable securities i.e. the daily opportunity
cost of holding cash
Example 1

A company requires a minimum cash balance of $6000 and the variance of
daily cash flows is estimated to be $2,250, 000. The interest rate on securities is
0.025% per day and the transaction cost for each sale or purchase of securities
is $20.
Required:
Calculate:
the spread
the upper limit
the return point
and interpret the results.


Solution
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Key points

The only reason for a business to exist is if it can generate positive cash
flows from operations.
However cash surpluses should not simply be left in the companys bank
account as this produces a very low return. Long term surpluses should be
invested into positive NPV projects, or used to pay a dividend.
Short term surpluses should be invested in low risk, highly liquid
investments such as Treasury Bills. The Baumol and Miller-Orr models
provide detailed models on how to manage transactions between cash and
short-term investments.


FOCUS
You should now be able to:

explain the role of cash in the working capital cycle;
describe the functions of and evaluate the benefits from centralised cash control and
treasury management;
apply the tools and techniques of cash management;
calculate optimal cash balances.

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EXAMPLE SOLUTION
Solution 1
Spread =
3
1
rate interest
flows cash of variance cost n transactio
3
4
3

=
3
1
0.00025
000 , 250 , 2 20
3
4
3

= 15,390

Upper limit = lower limit + spread
= 6,000 + 15,390
= 21, 390

Return point = Lower limit + ( spread)
= 6,000 + (15, 390/3)
= 11, 130
Interpretation:
if cash balance rises to $21,390 then invest $10,260 ($21, 390 $11, 130) in securities. This
reduces the cash balance to $11, 130
if cash balance falls to $6, 000, sell $5,130 of securities to replenish cash.
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