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.