Chapter 19

Cash and Liquidity Management

McGraw-Hill/IrwinCopyright © 2012 by McGraw-Hill Education (Asia). All rights reserved.

Learning Objectives

• To describe the concept of liquidity and components of liquid asset.

• To explain the motives of company holds cash.• To discuss the objectives and decisions of cash

management. • To elucidate the concept of float in cash flow.• To explain the methods used in managing cash inflow and

cash outflow.• To discuss the needs of company to balance between

holding cash and marketable securities.• To discuss the types of marketable securities in the market.

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Managing the Firm’s Investment in Current Assets

• The primary types of current assets that most firms hold are: Cash, Marketable securities, Accounts receivable, and Inventories.

• Cash and marketable securities are held to pay the firm’s bills on a timely basis. Holding too little cash and marketable securities could lead to default.However, holding excessive cash and marketable securities is costly since they earn little, or very low rates of return.

Reasons for Holding Cash

• Speculative motive– hold cash to take advantage of unexpected opportunities

• Precautionary motive– hold cash in case of emergencies

• Transaction motive– hold cash to pay the day-to-day bills

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Understanding Float

• Float – difference between cash balance recorded in the cash account and the cash balance recorded at the bank

• Disbursement float– Generated when a firm writes checks– Available balance at bank – book balance > 0

• Collection float– Checks received increase book balance before the bank

credits the account– Available balance at bank – book balance < 0

• Net float = disbursement float + collection float

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Example: Types of FloatYou have $3,000 in your checking account which is also reflected in your books. You just deposited $2,000 and wrote a check for $2,500.•What is the collection float?

– For the check deposited: Float = available balance – book balance = -$2,000

•What is the disbursement float?– For the check written: Float = available balance – book balance=

$2500

•What is the net float? – Net float = 2500 – 2000 = $500

•What is your book balance?– Book balance = $3000 + 2000 – 2500 = $2500

•What is your available balance? – Available balance = $3000 19-6

Example: Measuring Float

• Size of float depends on the dollar amount and the time delay

Delay = mailing time + processing delay + availability delay

• Cost of float is the opportunity cost of not being able to use the money.

• Float management – speeding up collections (reducing collection float) and slowing down disbursements (increasing disbursement float)

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Cash Collection

Payment Payment Payment CashMailed Received Deposited Available

Mailing Time Processing Delay Availability Delay

Collection Delay

One of the goals of float management is to try to reduce the collection delay. There are several techniques that can reduce various parts of the delay.

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Accelerating Collections• Lockboxes: are special post office boxes that allow banks toprocess the incoming checks and then send the information on

account payment to the firm. They reduce processing time and often reduce mail time because several regional lockboxes can be used.

Your company does business nationally, and currently, all checks are sent to the headquarters in Kuala Lumpur. You are considering a lock-box system that will have checks processed in three different states: Johor, Penang and Sarawak. The Kuala Lumpur office will continue to process the checks it receives in house.

• Cash Concentration: The practice of moving cash from multiple banks into the firm’s main accounts.

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Cash Disbursements

• Slowing down payments can increase disbursement float – but it may not be ethical or optimal to do this

• Controlling disbursements– Zero-balance account: maintain a master account so that when

checks are written on sub-accounts, cash is transferred from the master account to the sub-account to cover the checks; can maintain a smaller overall cash balance by utilizing this technique

– Controlled disbursement account: cash is transferred to bank account to cover the day’s anticipated payments

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Investing Cash

• Money market – financial instruments with an original maturity of one year or less

• Temporary Cash Surpluses– Seasonal or cyclical activities: buy marketable securities

with seasonal surpluses, convert securities back to cash when deficits occur

– Planned or possible expenditures: accumulate marketable securities in anticipation of upcoming expenses

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Figure 19.6

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Characteristics of Short-Term Securities

• Maturity– firms often limit the maturity of short-term investments

to 90 days to avoid loss of principal due to changing interest rates

• Default risk– avoid investing in marketable securities with significant

default risk• Marketability

– ease of converting to cash• Taxability

– consider different tax characteristics when making a decision

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Types of Money Market Securities

• Treasury Bills– Obligations of the government that mature in 30, 90 or 180

days.• Commercial papers

– Short-tern securities issued by finance companies, banks and corporations. Maturities range from a few weeks to 270 days.

• Certificates of deposits– Short-term loans to commercial banks,

• Repurchase agreements– Sales of government securities by banks. An investor buys

some treasury securities from a bond dealer and simultaneously agrees to sell them back at alter date at a specified high price.

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End of Chapter

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