An Introduction to Cash Management

Introduction Cash is the lifeblood of economic activity. Without cash, business cannot operate. Firms maintain cash balances for four primary purposes:1 1. Transactions needs 2. Precautionary purposes 3. peculative purposes !. Compensatin" balance purposes Firms re#uire cash balances to pay balances o$ed to suppliers, $a"es o$ed to employees, ta%es payable to "overnments, etc. Cash balances maintained to conduct such transactions reflect the firm&s transactions demand for cash. These cash balances may be maintained in cash re"isters, vaults, non'interest bearin" chec(in" accounts interest bearin" chec(in" accounts, money mar(et accounts and in )float) *chec(s $aitin" to be cleared by the ban(in" system or other$ise delayed in processin"+. ome firms may maintain balances in savin"s accounts that pay interest at rates belo$ competitive returns available else$here. ,ost firms $ill maintain the bul( of their cash balances in deposits or accounts at financial institutions. This transactions demand for cash balances accounts for the ma-ority of balances maintained by most firms. ome firms may maintain some cash balances for emer"encies or simply to ensure that they never run out. These precautionary balances or cash reserves usually account for a smaller percenta"e of the total levels maintained by the firm. .n addition, many firms maintain speculative balances to enable themselves to #uic(ly ta(e advanta"e of ne$ investments, shifts in interest rates and fluctuations in e%chan"e rates. For e%ample, $hen interest rates are lo$, firms maintain hi"her speculative cash balances/ $hen interest rates rise, firms commit their speculative balances to the hi"her yield securities. 0o$ever, money mar(et accounts allo$ firms to maintain hi"hly li#uid interest'bearin" assets that can be #uic(ly converted into lon"er'term interest'bearin" debt certificates. Firms that maintain chec(in" accounts $ith commercial ban(s are fre#uently re#uired to maintain minimum balances $ith their ban(s. These minimum balances, referred to as compensatin" balances, are re#uired to compensate commercial ban(s for the chec(in" account services they provide the firm or to avoid fees normally imposed for chec(in" and other ban( services. uch compensatin" balances "enerally do not accrue interest or accrue interest at belo$'mar(et rates. Thus, the commercial ban( obtains the free *or ine%pensive+ use of the firm1s money in e%chan"e for providin" 2free3 chec(in" account services. ,ost firms $ill prepare cash bud"ets, pro-ectin" cash inflo$s and cash outflo$s over "iven time periods. .n many instances, the firm1s cash outflo$s for a particular day or $ee( $ill e%ceed its inflo$s for that period. The firm $ill $ish to maintain a positive cash balance *surplus+ to ensure its ability to operate durin" these periods. ,any firms find the use of various cash mana"ement models helpful for determinin" optimal cash balances, ho$ much additional cash $ill be re#uired $hen balances run lo$ and $hen these balances should be replenished. Perhaps, the more popular of the cash mana"ement models are based on the 4aumol and ,iller'5rr models. 6s $ith all financial constructs, these cash mana"ement models re#uire several assumptions $hich are often not applicable in reality. .n many cases, the fact that certain

assumptions may be violated in reality $ill barely affect the use or implications of these models. 0o$ever, if necessary, these models are simple and fle%ible enou"h to be easily adapted to more realistic conditions. 7#ually important is that these models ma(e it easy to see ho$ certain factors impact the firm&s optimal cash balances. 4oth the 4aumol and ,iller'5rr models assume that the firm incurs an opportunity cost by maintainin" cash balances. That is, $hen the firm maintains a cash balance, it for"oes the opportunity to invest money in interest or return'bearin" assets. Thus, the firm1s opportunity cost is the fore"one interest or returns on money it could have invested more profitably else$here. 8ar"er cash balances $ill imply lar"er fore"one interest opportunity costs. econdly, these models assume that the firm incurs transactions costs $hen it li#uidates assets in order to obtain cash. *The ,iller'5rr model assumes that the firm also incurs transactions costs $hen it converts surplus cash to return'bearin" securities.+ That is, $hen the firm sells assets *such as mar(etable securities+ to replenish its cash balances, it incurs a transactions cost *such as a fi%ed bro(era"e fee+. The more often the firm must transact to replenish its cash balances, the hi"her $ill be its total transactions costs. 0ence, these models are structured to find the cash balance that minimi9es the total costs associated $ith maintainin" and obtainin" cash The Baumol Cash Management Model The 4aumol Cash ,ana"ement ,odel is deterministic in that it assumes that the firm1s demand for cash over the relevant time period is (no$n $ith certainty. For e%ample, Pol( Company mana"ement may (no$ $ith certainty that the firm $ill re#uire :1;;,;;; over the ne%t year. .f the company&s cash balance declines by e#ual amounts at all times *for e%ample, the firm spends the same amount each day+, simply startin" the year $ith a cash balance of :1;;,;;; $ill mean that the firm, over the course of the year, $ill maintain an avera"e cash balance of :<;,;;;. Thus, the firm be"ins the year by orderin" an initial cash balance of :1;;,;;; and permits it to continue to drop until the balance reaches 9ero. 5n the other hand, if the firm $ere to be"in the year $ith a cash balance of :1;,;;; then obtain cash nine more times over the ne%t year *for a total of ten orders+, its avera"e cash balance $ill be only :<;;;. The avera"e cash balance declines as the firm orders cash more fre#uently. maller avera"e cash balances allo$ more capital to be invested in return' and interest'bearin" assets. =ecreasin" the avera"e cash balance $ill increase the number of transactions that the firm e%ecutes for cash and the firm&s overall transactions costs. 6t the same time, the firm&s avera"e cash balance $ill decline as $ill the interest or returns that it fore"oes * ee Fi"ure 1+. Where *c+ is the amount of cash obtained each time the firm replenishes its balance and *%+ is the total cash demand over the relevant time period, the avera"e cash balance *av"+ can be determined as follo$s: c *1+ av" > 2 . The firm1s fore"one interest or return cost *ic+ is simply the avera"e cash balance times the interest or return rate the firm could have earned had it other$ise invested in mar(etable securities: c *2+ ic > 2 > av" i

i $here *i+ is the interest rate fore"one by the firm $hen maintainin" cash balances. Cash balances re#uire the firm to fore"o interest or returns on mar(etable securities or other assets. .n our

e%ample, if the annual interest rate fore"one by the Pol( Company $ere 1;?, its total fore"one interest cost over the year $ould be :<;;.

Cost

Tot al cash bal ance cost ( $) For egone i nt er est cost ( i c) Mi ni mum cash bal ance cost Tr ansact i on cost ( t r c)

C*

Figure 1: Costs associated with obtaining and maintaining cash balances

Cash Balance

C*

C@ 2

0 Time

Figure 2: Cash balances over time: Baumol Model .n Fi"ure 2, the firm be"ins the time period $ith a cash balance of *c+. .t then spends this money in e#ual amounts each day until the balance reaches 9ero. 6t this point, the firm cannot operate unless it obtains additional cash. To obtain this cash, the firm en"a"es its bro(er to sell mar(etable securities/ the receipts of the sale are used to replenish cash balances and the process continues. 7ach time the bro(er is en"a"ed to sell mar(etable securities enablin" the firm to replenish its cash balances, a transactions cost is incurred. .n the 4aumol ,odel, any revenues received by the firm are immediately converted into return'bearin" assets/ thus, the firm must li#uidate a portion of its return'bearin" assets to obtain cash. When the firm sells mar(etable securities to raise cash, it $ill incur a fi%ed bro(era"e fee *4+ for each transaction. The total number of transactions e%ecuted by the firm per time period is simply the total cash demand over that period divided by the cash order #uantity.

X *3+ tr > c

Therefore, the total transactions costs incurred by the firm over the relevant time period is determined: *!+ trc > X c B = tr B .

.f the cash order #uantity for the Pol( Company $ere :1;,;;;, the total number of transactions for cash e%ecuted by the firm $ould be 1;. .f the bro(era"e fee per transaction $ere :<;, the total transactions costs incurred by the Pol( Company $ould be :<;;. The total costs associated $ith cash balances for a firm is simply the sum of its fore"one interest and bro(era"e costs: X c

*<+ : > c B + 2 i = ic + trc The firm1s primary ob-ective $ith respect to cash mana"ement policy should be to minimi9e these costs yet remain able to operate effectively. .f Pol( Company mana"ement reali9ed that it re#uires :1;;,;;; in cash over a "iven year, its ob-ective $ill be to choose a cash order #uantity enablin" it to minimi9e the total costs associated $ith obtainin" and maintainin" cash balances. Therefore, it $ill minimi9e *:+ $ith respect to *c+. This optimum *c+ level $ill enable the firm to determine its optimum avera"e cash balance *simply c@A2+ and to determine the optimum number of security sales for cash over the year *BAc+. The optimal cash order #uantity is "iven by 7#uation C: *C+ c @ = 2 BX i ince c@ is that order #uantity that enables the firm to minimi9e the total costs associated $ith its obtainin" and maintainin" cash balances, c@ is the optimum cash order #uantity. The Pol( Company $ill be able to determine its optimum cash order #uantity usin" 7#uation *C+, "iven its (no$n cash demand of :1;;,;;;, the ten percent interest rate on mar(etable securities, and the :<; bro(era"e cost per transaction: 2 :<; :1;;,;;; = .1

c@ =

:1;;,;;;,;;; = :1;,;;;.

The company $ill maintain an avera"e cash balance of :<,;;; *from 7#uation D1E + and $ill en"a"e its bro(er ten times over the course of the year *from 7#uation D3E+ to li#uidate mar(etable securities. ince the company $ill order cash ten times over the year, it $ill, on avera"e, order cash every 3C.< days. Pol(1s total fore"one interest cost $ill be :<;;/ its total transactions costs over the year $ill be :<;;. The total cost to the Pol( Company of obtainin" and maintainin" cash balances $ill be :1;;;. Fo level of *c+ $ill result in lo$er total cash balances costs. Fotice that the fore"one interest cost is e#ual to the total transactions costs in the Pol( Company e%ample. This e#uality $ill hold only $hen the firm chooses optimum cash order #uantities and allo$s its cash balances to diminish to 9ero before replenishin" them. .n the follo$in" section, the firm $ill not permit its cash balance to decline belo$ some minimum acceptable level/ therefore, the optimum cash order #uantity $ill not result in the firm1s transactions costs e#ualin" its fore"one interest costs. The ma%imum cash balance is no$ *c+ plus *min+ and the avera"e cash balance is simply the sum of the ma%imum and minimum balances divided by t$o. The total costs associated $ith obtainin" and maintainin" cash balances are determined as follo$s:
Cash Balance

C*+Min
2

C @ +2 Min

Min

Figure 3: Cash balances over time, Baumol Model with minimum acce table balances

Time

*C+

c@ =

2 BX i

0o$ever, since the avera"e cash balance is hi"her $hen the firm establishes a non'9ero minimum acceptable cash balance, its fore"one interest and total cash balances costs $ill be hi"her. The Miller!"rr Cash Management Model Gse of the 4aumol Cash ,ana"ement ,odel re#uires that the firm be able to forecast cash demand $ith some de"ree of accuracy, that the firm obtain cash only by sellin" inventories, and that this cash be spent in e#ual increments every day. The ,iller'5rr ,odel does not re#uire the firm to ma(e a forecast of cash demand/ it only re#uires that the firm be able to associate a variance $ith uncertainty re"ardin" cash demand or balances. The model further assumes that the firm is able to obtain cash from revenues, but this source of cash may not be sufficient to cover the firm1s needs for cash. Therefore, the firm must li#uidate securities to obtain cash $hen revenues are insufficient to cover the firm1s cash needs. 4ecause the firm has only limited control over the ma"nitude and timin" of its revenues, it may find its cash balances risin" to unacceptably hi"h levels. When the firm1s cash balances are too hi"h, it for"oes too much interest and must purchase securities to dispose of the surplus cash. The firm should first establish some minimum acceptable cash balance. =etermination of this minimum acceptable level should account for the cost to the firm of entirely depletin" its cash balances and the len"th of time elapsin" bet$een the point $hen the firm orders the li#uidation of securities and the point $hen the firm actually receives the receipts from the li#uidation. The cost of depletin" the cash balance to 9ero may be a function of interest imposed by a ban( for a short'term loan or credit line. Henerally, past mana"erial e%perience is the best startin" point for settin" this minimum cash balance.

Cash Balance

Balance Min + 3Z

Max

Min+Z Min

rtp

Min

Time

Figure #: Cash Balances "ver Time: The Miller!"rr Model The effects of increased interest rates *or returns on mar(etable securities+ $ill result in decreased levels of *9+, *ma%+ and *rtp+. Therefore, the firm, on avera"e, $ill maintain smaller cash balances. The firm sets a lo$er ma%imum acceptable balance to better enable it to ta(e advanta"e

of the increased interest rates and sets a lo$er *rtp+ to ensure that its avera"e cash balances are smaller. .ncreased variance or uncertainty re"ardin" future cash balance levels $ill increase *9+, thereby $idenin" the spread bet$een the minimum and ma%imum acceptable cash balance levels. First, consider the certainty case. 0ere, the variance of future cash balances is 9ero, resultin" in a *9+ level of 9ero, $hich $ill cause the ma%imum acceptable cash balance to al$ays e#ual the minimum acceptable balance. .n this case, the firm $ill never have to e%ecute mar(etable security transactions to dispose of or to obtain cash/ cash balances are constant. 6s the variance of cash balances increase, the firm must e%ecute more mar(etable securities transactions and $ill increase the *ma%+ and *rtp+ levels to balance out transactions costs $ith fore"one interest costs.

$%&'TI"(' A() *+"B,&M' 1. What costs or disadvanta"es mi"ht be associated $ith firms maintainin" cash balances that are too smallJ What costs or disadvanta"es mi"ht be associated $ith firms maintainin" cash balances that are too lar"eJ 2. The Capone Company has determined that its operatin" circumstances are #uite suitable for use of the 4aumol Cash ,ana"ement ,odel. The company consistently earns a five percent annual rate of return on its mar(etable securities and re#uires a total of :2;;,;;; in cash each year to maintain its production. Transactions costs are :<; each time Capone li#uidates mar(etable securities. =etermine the follo$in" for the Capone Company: a. its optimum cash order #uantity b. its optimum avera"e cash balance c. the optimum number of securities li#uidations for cash per year d. the optimum number of days bet$een orders for cash e. its total annual transactions cost incurred by usin" the optimum cash order #uantity f. its annual fore"one returns cost ". the minimum total cost associated $ith obtainin" and maintainin" cash balances 3. What $ould be the total costs associated $ith cash balances in Problem 2 if Capone orders :1;,;;; each time it li#uidates mar(etable securitiesJ What $ill be the total costs if Capone li#uidates :2<,;;; in securities each time it runs out of cashJ !. What $ill be the optimum cash order #uantity if Capone $ished to establish a minimum acceptable cash balance of :3,;;;J What $ill be its ne$ total costs associated $ith cash balancesJ <. The Felson Company has determined that its operatin" circumstances re#uire the use of the ,iller'5rr Cash ,ana"ement ,odel to mana"e its cash balances. The standard deviation of the company1s daily cash balances has been sho$n to be :2,;;;, and mana"ement feels this fi"ure also reflects future balance variability. Felson earns an avera"e daily return of .;<? on its mar(etable securities and incurs an avera"e bro(era"e fee of fifty dollars each time it en"a"es a securities transaction. ,ana"ement has determined that it cannot permit the company1s cash balance to fall belo$ :<,;;;. =etermine the follo$in" for the Felson Company: a. its )9) value b. its )return'to'point) c. its optimum ma%imum cash balance d. the optimum dollar value of mar(etable securities to be sold $hen the minimum cash balance is reached e. the dollar value of mar(etable securities to be purchased $hen the ma%imum cash balance is attained f. ne$ solutions for parts *a+ throu"h *e+ if the standard deviation of daily cash balances $ere to rise to :<,;;;

'olutions 1. Too small: can1t transact easily, hi"her order costs for cash, ris(y Too hi"h: hi"h fore"one interest costs, ris(y 2 <; 2;;,;;; = 2;,;;; a. c @ = .;< b. 2;,;;;A2 > 1;,;;; c. % > 2;;,;;; > 1; c 2;,;;; d. 3C< > 3C.< 1; e. % K 4 > 1; K <; > <;; c f. 2;,;;; K .;< > C@ K i > <;; 2 2 ". <;; L <;; > 1;;; 3. !. a. 12<; a. same/ 2;,;;; b. B K 4 L C@ L 2 min K i > <;; L C<; > 11<; C@ <. a. z =
3

2.

b. 1;2<

3 :<; !,;;;,;;; !. ;;;<

= C,CI!.32

b. r.t.p. > min L 9 > 11,CI!.32 c. ma% > min L 39 > 2<,;M2.IN d. 9 > r.t.p. ' min. > C,CI!.32 e. ma% ' r.t.p. > 29 > 13,3MM.C< f. a:12,331.;C b: 1N,331.;C c: !1,II3.1M d:12,331.;C e: 2!,CC2.12