Discuss why firms hold cash and marketable

securities, and how the levels they hold of each

relate to those motives.
Demonstrate the three basic strategies for the
efficient management of cash using the firm’s
operating and cash conversion cycles.
Explain float, including its three basic
components, and the firm’s major objectives with
respect to collection float and disbursement float.
• Review popular techniques for speeding up
collections and slowing down disbursements, the
role of banking relationships, and international
cash management.
• Understand the basic characteristics of
marketable securities and the key features of
popular government and non-government issues.
• Describe the Baumol model and Miller-Orr model
and how they can be used to determine the
optimum quantity in which to convert marketable
securities and cash.
Cash is often called liquid assets or
nonearning assets.
It is needed to pay salaries, raw materials,
repayment of loan and others.
Specifically there are 3 major motives of
holding cash which are:
Transaction Motives
Precautionary Motives
Speculative Motives
Transaction  The level of funds required due to the ordinary course of
motives business
 It is needed to meet ordinary payment such as paying
bills, employees’ salaries, creditors and etc
Precautionary  The funds needed to meet contingency requirement
motives  Funds needed to reserve for emergency needs, unforeseen
fluctuation in cash flows or unexpected seasonal needs
 It serves as a safety cushion against the unexpected cash
drain that may arise because of risk and uncertainty
regarding the future
Speculative  To hold sufficient cash to enable the firm to take
motives advantage of any unexpected bargain or opportunities
which may arise from time to time such as trade discounts
or some short term investments
Compensating  Are necessary to compensate financial institutions for
balances providing loans and services.
 Requires the firm to maintain a minimum level of money it
its bank account, normally based on a certain percentage
of the loans taken.
It involves having the optimum amount of
cash in hand at the right time
It will also help the firm hold its cash longer
and collect cash more quickly
Reasons to have an efficient cash
management techniques are:
To establish proper procedures for collection
from debtors and payment to creditors
To establish adequate cash floats and
minimum cash balances
To synchronize cash inflows and outflows
The goal of cash management is to
minimize the cash balance while
maintaining a certain level of
liquidity.
Too much liquidity reduces return,
whereas too little, increases risk
exposure.
Cash Flow Management

Estimation Cash Requirements

Developing Borrowing/ Investment Strategies

Involves the process of controlling
the movement, inflows, and
outflows, of the firm to minimize the
cash required to support working
capital.
Slowing disbursements and speeding
up collections can do this.
The estimation of cash requirements
involves the preparation of cash
budget, which allow the firm to plan,
coordinate, and control the actual
cash flow through the firm.
Once the cash flow has been
estimated, the appropriate level of
cash holdings can be established.
With the establishment of the
appropriate cash balance, the
strategies to finance any cash
shortfalls can be developed ahead of
time.
In case of cash excess, efficient
investment strategies can be
developed to use idle temporary
liquidity and earn return.
 Speeding up
receipts

Slowing up Management of Cash

disbursement firm’s cash flow budgeting

Maintaining Determining the

good banking optimal cash
relationship balances

Short-term
Marketable securities
financing
investment strategies
strategies for cash
for cash excess
shortfalls

The cash will take care of the profits if the firm takes care of the cash.
Make all payments as late as
possible. However, take advantage
of any favorable discounts offered by
suppliers.
Make all collections as soon as
possible without losing future sales
and use cash discounts to encourage
early payments.
Turn over the inventory as quickly
as possible and avoid stockouts
that might result in shutting down
the production line or any loss in
sales.
Raw materials
purchases Inventory
(payable processing
generated)

Payment for
Finished
purchases
goods
(payable
inventory
exonerated)

Payment
Sale of goods
received
(receivable
(receivable
generated)
exonerated)
The objective of a firm is to run the
business effectively without running
out of cash.
Therefore the firm must keep a
minimum cash balance.
MOC will allow the firm to invest in
various alternatives and to repay
their debts when they are due.
The Operating Cycle (OC) is the
time between ordering materials and
collecting cash from receivables.
The Cash Conversion Cycle (CC) is
the time between when a firm pays
it’s suppliers (payables) for inventory
and collecting cash from the sale of
the finished product.
 Company A
OC = 110 days

AAI = 70 days ACP = 40 days

Purchase raw materials Sell finished goods on

on credit credit
Accounts Payable Accounts Receivable

0 10 20 30 40 50 60 70 80 90 100 110

Collect accounts
Pay accounts payable
receivable
Cash Outflows
Cash Inflows

APP = 30 days CC = 80 days

 OC = AAI + ACP
= 70 days + 40 days
= 110 days

CC = OC - APP
= AAI + ACP - APP
= 70 days + 40 days - 30 days
= 80 days
Where
AAI = Average Age of Inventory
ACP= Average Collection Period
APP = Average Payment Period
Cash cycle is a measure of the
amount of cash tied up, lower
operating cycle (OC) and cash cycle
(CC) is better as the firm could
recover the cash outlay in a shorter
period.
A measure of how effective cash is
managed in the firm is the cash
turnover (CTO).
Refers to the number of times each
year the firm’s cash is actually being
turned over
CTO = 360
CC
= 360
80
= 4.5 times
The firm’s cash cycles directly affect
the amount of cash that need to be
held at any given time to support
operations.
This amount represents the
minimum operating cash (MOC) to
avoid any cash shortages in meeting
all its payments.
It is the minimum amount of money
needed by the company per cycle

MOC = Total annual cash outlay

CTO
Lets assume that the firm’s annual cash
expenditures are expected at RM300,000.
MOC = Total annual cash outlay
CTO
= 300,000
4.5
= RM66,666.67
Therefore the firm needs RM66,666.67 as a
minimum cash requirement to support the
firm’s day-to-day operations without risk of
technical insolvency.
 Company A
OC = 110 days

AAI = 70 days ACP = 40 days

Purchase raw materials Sell finished goods on

on credit credit
Accounts Payable Accounts Receivable

0 10 20 30 40 50 60 70 80 90 100 110

Collect accounts
Pay accounts payable
Cash Outflows
receivable
Cash Inflows
Before

APP = 30 days CC = 80 days

Lets assume that Company A is able
to negotiate a better credit term with
its suppliers from 30 days to 35
days;
Improve production and selling that
reduces AAI to 60 days;
Decrease average collection period to
33 days.
 OC = 60 days + 33 days
= 93 days
The changes CC = 60 days + 33 days - 35 days
resulted in a
shorter
= 58 days
operating
CTO = 360
cycle, cash
cycle and 58
thus a higher
cash = 6.21 times
turnover.
MOC = 300,000
6.21
= RM48,309.17
 Company A
OC = 93 days

AAI = 60 days ACP = 33 days

Purchase raw materials Sell finished goods on

on credit credit
Accounts Payable Accounts Receivable

0 10 20 30 40 50 60 70 80 90 100 110

Collect accounts
Pay accounts payable
Cash Outflows
receivable
Cash Inflows
After

APP = 35 days CC = 58 days

MAX Company, a producer of dinnerware, sells all its
merchandise on credit.
The credit terms require customers to pay within 60 days of
a sale.
On average, it takes 85 days to manufacture, warehouse,
and ultimately sell a finished good. In other words, the
average age of Inventory (AAI) is 85 days.
It also takes an average of 70 days to collect on its
accounts receivable (ACP).
The credit terms for MAX’s raw material purchases currently
require payment within 40 days and employees are paid
every 15 days.
The firm’s weighted average payment period (APP) for raw
materials and labor is 35 days.
Calculate the OC and CC.
It is crucial for a firm to minimize its
cash cycle and maximize cash
turnover, without sacrificing the
firm’s liquidity and profitability.
As the firm increases its CC (through
reducing the AAI and/or ACP and/or
increasing the APP), the CTO will
decrease and MOC cash will increase.
Increasing Average Payment Period
Involves delaying payments as late as
possible without damaging the firm’s
credit rating.
Favorable cash discount should not be
ignored, as the opportunity cost is high
if not taken.
Reducing Average Inventory Age
Increase inventory turnover as quickly
as possible by:
Efficient management of inventories
Better production planning, scheduling and
control
Effective sales forecasting
Synchronize the production and demand.
Reducing Average Collection Period
Involves speeding up collection of
account receivables without losing
potential sales.
The use of proper techniques such as
changes in credit policies and collection
policies that will improve collection
period will benefit the company.
The effects of lower cash cycle are
quite significant for large firms with
cash reserves and cash outlays that
run in millions of Ringgit.
Proper cash management will have a
direct impact on the firm’s liquidity
and profits.
Determining a firm’s desired cash
level involves a tradeoff between the
opportunity costs of holding too
much cash and the costs of holding
too little cash.
Cost RM

Carrying Cost
Total Cost

The minimum
total costs
occur where
the carrying
cost and The more
trading cost is a firm
equal. This is holds
the optimal cash, the
Trading Cost
cash balance lower is
that the firm the
should have. trading
cost.
Size of Cash Balance
• Cash conversion models are used to help
determine the optimal quantity of marketable
securities to convert into cash when needed (and
vice versa).
• The cash conversion quantity depends on a
number of factors, including the fixed cost of
transferring funds between cash and marketable
securities, the rate of interest, and the firms
demand for cash.
• The objective of these models is to balance the
costs and benefits of holding cash versus
investing in marketable securities.
William J. Baumol developed a model “The
transactions Demand for Cash: An
Inventory Theoretic Approach” which is
usually used in inventory management and
cash management.
It is a trade off between opportunity cost/
carrying cost/ holding cost and the
transaction cost.
As such firm attempts to minimize the sum
of the holding cash & the cost of converting
marketable securities to cash.
Assumptions:
Cash inflow and outflow are certain;
It does not take into account any
seasonal or cyclical trends.
Implications:
The higher the interest rate (opportunity
cost), the lower will be the optimal cash
balances;
The higher the trading cost, the higher
will be the optimal cash balance.
Let us assume that the firm sells securities
and starts with a cash balance of C Ringgit.
When the firm spends cash, its cash
balance starts decreasing and reaches zero.
The firm again gets back its money by
selling marketable securities.
As the cash balance decreases gradually,
the average cash balance will be:

Average Cash Balance = C

2
This can be shown in following figure.
The firm incurs a cost known as
holding cost for maintaining the cash
balance.
It is known as opportunity cost, the
return inevitable on the marketable
securities.
If the opportunity cost is k, then the
firm’s holding cost for maintaining an
average cash balance is as follows:
Holding cost = k (C )
2
Whenever the firm converts its marketable
securities to cash, it incurs a cost known as
transaction cost.
Total number of transactions in a particular
year will be total funds required (T), divided
by the cash balance (C) i.e. T/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 = c (T)
C
 Holding cost = k (C )
2
Transaction cost = c (T)

C
Total cost = k (C) x c (T)

2 C
Here,
k, is the opportunity cost
T is the total funds requirement
C is the cash balance
c is per transaction cost
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 between the holding cost
and the transaction cost.
The optimum cash balance, C* is obtained
when the total cost is minimum.
Formula for optimum cash balance
C* = √ (2cT)
k

Where,
C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash
balances.
The management of JanCo, a small distributor
of sporting goods, anticipates $1,500,000 in
cans outlays (demand) during the coming
year.
The firm has determined that it costs $30 to
convert marketable securities into cash and
vice versa.
The marketable securities portfolio currently
earns an 8% rate of return.
What is the firm’s optimal cash balance?
• Like other financial decisions, the goal of the firm
is to maintain the level of cash and marketable
securities that maximizes shareholder and firm
value.
• Balances that are too high will diminish
profitability -- and balances that are too low will
accentuate risk.
• Although the more sophisticated mathematical
estimation models are beyond our scope, the
overriding objective is to balance risk against
return.
• In addition to earning a return on
temporarily idle funds, marketable
securities serve as a safety stock of cash
that can be deployed to satisfy unexpected
demands for funds.
• For example, if a company wishes to
maintain $70,000 of liquid funds and a
transactions balance of $50,000 -- $20,000
would be held as marketable securities.
Are near-cash items and considered
as part of cash.
Acts as a cushion against technical
insolvency.
It is as liquid as cash as it takes a
relatively short time for conversion
to cash without losing face value.
Marketable securities are short-term,
interest bearing money market
instruments that can easily be
converted into cash.
Securities that are most commonly-
held as part of a marketable
securities portfolio can be segmented
into two groups -- government issues
and non-government issues.
Reasons for holding marketable
securities:
As a substitute for cash
For precautionary purposes as a cushion
against unexpected shortage of bank credit
and other emergency cash outflows.
As a temporary investment
Investments in marketable securities to:
Finance seasonal or cyclical need for cash; and
Meet known future financial requirements.
Marketable securities portfolio
consists of different types of
securities that differ in:

Maturity Liquidity

Returns
The choice of securities in the
portfolio is in accordance to the
nature of cash available for
investment:
Ready Cash
• For immediate cash needs
Segment

Controllable • For expenditures that are

Cash Segment predictable

Free Cash
• For speculative purposes
Segment
 • Concerned with the safety of principal

Security investment due to the risk of default in

principal or interest payment and capital
loss.

• Refers to the ease of converting the

Liquidity securities to cash without losing the face
value.

Yields • Represents the tradeoff between risk and

returns.
Treasury Bills (T-Bills)
Treasury Notes (T-Notes)
Negotiable Certificate of Deposits
(NCDs)
Commercial Paper (CP)
Banker’s Acceptance (BA)
It is a Government Issue and
represents the obligation of the
Treasury Department.
Maturities not exceeding one year;
most of the T-bills mature in 91 – 182
days, with longer maturity such as 9
months and one year.
The treasury holds weekly acution at a
discount with the smallest
denomination of RM1,000 and are
considered as risk-free.
Payable to order and entitle the holder
the payment of a fixed deposit sum on
maturity.
Provides investment outlets for short
term surplus funds of commercial
banks, merchant banks, discount
houses and finance companies.
Evaluation: High liquidity with strong
secondary market, lowest risk, and low
return.
Similar to T-Bills in that it is the
obligation of the treasury Department.
Maturity is between 1 – 7 years.
T-notes are part of marketable
securities because of its security and
liquidity.
Evaluation: High liquidity with strong
secondary market, lowest risk, and
return is slightly higher than T-bills.
A certificate of deposit, USA, 1932
A document which certifies that a
certain sum of Ringgit has been
deposited with a financial institution
at a specified rate of interest with a
specified maturity period.
Is a negotiable instrument as an
evidence of deposit in a commercial
bank.
The amount (smallest RM100,000)
and the maturity (commonly 30
days) are dependant on the
investor’s (depositor’s) needs.)
Evaluation: High liquidity with strong
secondary market, moderate risk
that depends on the bank involved
and high return.
A short-term unsecured promissory
note issued by a large firm with high
credit standing.
Maturity ranging from 3 – 270 days.
Longer maturity requires a formal
registration.
Evaluation: Low liquidity with weak
weak secondary market, moderate risk
(depending on the issuer) and return is
slightly lower than NCDs.
Bills of exchange which are drawn on
and accepted by commercial or
merchant banks in Malaysia.
Created out of a bona fide trade
transaction such as to finance import
and export of goods to/from Malaysia
and sale and purchase of goods and
services within Malaysia.
Similar to cashier’s check payable in
the future with typical maturity of 30
days or 180 days.
Arises from a short-term arrangement
between a purchaser and its bank for
financing of certain transactions.
The purchaser with its bank approval,
issues a draft, on which payment is
contingent on some events, to the seller
for the amount purchased.
The seller who holds the BA may then sell
it at a discount in the secondary market to
obtain immediate funds.
In the Malaysian money market,
major securities are:
Bankers Acceptance
Negotiable Money Market Instruments
Malaysian Government Securities
Malaysian Government Treasury Bills
Cagamas Bonds
The cash management and
marketable securities are highly
dependant on each other, therefore it
must be managed concurrently.
These two liquid assets represent the
firm’s liquidity that will determine its
long-term viability and ability to
increase stockholders’ wealth.
1. Financial Analysis by Omar Samad
and Mohd Sabri Hj Mohd Amin,
InED, UiTM Shah Alam.
2. Financial Management by Rohani A.
Ghani and Mohd Sabri Hj Mohd
Amin, InED, UiTM Shah Alam.
3. Financial Market and Institution by
Rohani A. Ghani and Ibrahim Ab.
Rahman, InED, UiTM.
End of Chapter 6