CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
chases from others. Cash flows into the firm as customers pay for the goods and services they purchase. When we refer to cash, we mean the amount of cash and cash-like assets—currency, coin, and bank balances. When we refer to cash management, we mean management of cash inflows and outflows, as well as the stock of cash on hand.
Monitoring Cash Needs We can monitor our cash needs through cash forecasting. Cash forecast-
ing is analyzing how much and when cash is needed, and how much and when to generate it. Cash forecasting requires pulling together and con- solidating the short-term projections that relate to cash inflows and out- flows. These cash flows may be a part of your capital budget, production plans, sales forecasts, or collection on accounts.
To understand the cash needs and generation, you have to under- stand how long it takes to generate cash, once an investment in inven- tory is made. We’re referring to the operating cycle—the time it takes to make cash out of cash. For example, in 2001, General Electric (GE) had an operating cycle of 90 days; it took GE, on average, 62 days to con- vert its investment in inventory into a sold product and, on average, 28 days to collect on its customer accounts. 1
If we consider cash disbursements, we get a better picture of the net cash—the net operating cycle—the time it takes to make cash from cash plus the time we delay payment on our purchases:
Net operating cycle = Operating cycle – Number of days of purchases GE, for example, had a net operating cycle of 41 days in 2001. It took,
on average, 49 days to pay for its purchases. 1 This calculation assumes that all sales are on credit.
Management of Cash and Marketable Securities
Estimating our net operating cycle gives us information on how long it takes to generate cash from our current assets. The longer the net operating cycle, the more cash we need on hand.
To understand our cash flows, we also have to have a fairly good idea of the uncertainty of our cash needs and cash generation. Cash flows are uncertain because sales are uncertain, and so is the uncertainty regarding when we will collect payment on what we do sell, as well as uncertainty about production costs and capital outlays. Forecasting cash flows requires the coordination of marketing, purchasing, produc- tion, and financial management.
Reasons for Holding Cash Balances Firms hold some of their assets in the form of cash for several reasons.
They need cash to meet the transactions in their day-to-day operations. Referred to as the transactions balance, the amount of cash needed for this purpose differs from firm to firm, depending on the particular flow of cash into and out of the firm. The amount depends on:
1. the size of the transactions made by the firm; and
2. the firm’s operating cycle, which determines its cash outflow and inflow, depending on the firm’s production process, purchasing poli- cies, and collection policies.
There is always some degree of uncertainty about future cash needs. Firms typically hold an additional balance, referred to as a precaution- ary balance, just in case transactions needs exceed the transactions bal- ance. But how much to keep as a precaution depends on the degree of the transactions uncertainty—how well we can predict our transactions needs. For example, a retail store has a good idea from experience about how much cash to have on hand to meet the typical day’s transactions. In addition to what is needed for a typical day, the retail store may keep more cash on hand to meet a higher than usual level of transactions.
In addition to the precautionary balances, firms may keep cash on hand for unexpected future opportunities. Referred to as a speculative balance, this is the amount of cash or securities that can be easily turned into cash, above what is needed for transactions and precaution. The speculative balance enables a firm to take advantage of investment opportunities on short notice and to meet extraordinary demands for cash. For example, an automobile manufacturers may need an additional cash cushion to pay its bills in case a wildcat strike closes down a plant.
In addition to the cash balances for transactions, precautionary, and speculative needs, a firm may keep cash in a bank account in the form of
a compensating balance—a cash balance required by banks in exchange
MANAGING WORKING CAPITAL
for banking services. By keeping a balance in an account that is non- interest earning or low-interest earning, the firm is effectively compen- sating the bank for the loans and other services it provides. Some bank loans and bank services require a specified amount or average balance
be maintained in an account. Costs Associated with Cash
There is a cost to holding assets in the form of cash. Because cash does not generate earnings, the cost of holding assets in the form of cash, referred to as the holding cost, is an opportunity cost—what the cash could have earned if invested in another asset.
If a firm needs cash, it must either sell an asset or borrow cash. There are transactions costs associated with both. Transactions costs are the fees, commissions, or other costs associated with selling assets or borrow- ing to get cash; they are analogous to the ordering costs for inventory.
Determining the Investment in Cash How much cash should a firm hold? For transactions purposes, enough
to meet the demands of day-to-day operations. To determine how much is enough transactions purposes, we compare the cost of having too much cash to the cost getting cash—in other words, we compare the holding cost and transactions cost.
As you hold more cash, its holding cost increases. With more cash on hand, the costs of making transactions to meet your cash needs for operations declines. That’s because with larger cash balances, you need fewer transactions (selling marketable securities or borrowing from a bank) to meet your cash needs.
We want to have on hand the amount of cash that minimizes the sum of the costs of making transactions to get the cash (selling securities or borrowing) and the opportunity cost of holding more cash than we need.
We will look at the Baumol Model and the Miller-Orr Model to help us decide on the level of cash we need and when we need it.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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