Cash Management Paper
Cash is the lifeblood of companies. Cash provides the liquidity needed to meet everyday obligations owed to suppliers and creditors and the flexibility to take advantage of new opportunities that may arise. Managing cash is a delicate issue for many firms. For businesses cash is the key to daily operations, but cash is a non-earning asset. Dollars tied up in cash could be earning higher rates of return if invested in other areas. Large corporations spend considerable time and resources in cash management; dollars are transferred back and forth between marketable securities and cash accounts that earn a higher rate of return. Negotiated credit lines serve to supplement depleted cash during periods of shortage. Short-term financing is a portal that allows firms to operate with a low cash balance. The first part of this paper will explain the various cash management techniques. The second half of the paper will address the types of short-term financing a financial manager of a firm has to choose from.
Cash Management Techniques
While private citizens are often taught conservative cash management practices, most companies do not want to keep any more cash on hand than absolutely necessary. Companies must keep some cash for transactions, bank payments, and potential emergencies; although, the opportunity cost of holding an excess of cash rather than reinvesting it into current assets or growing the firm’s fixed assets is often significant. Multiple techniques can be used by a firm to manage its cash. These techniques are broken down into three separate categories: collections and disbursements, management of accounts receivable, and inventory management.
Collections and Disbursements
Float is the difference between the firm’s recorded amount and the amount credited to the firm by the bank. This is the result of a time delays in mailing, processing, and clearing checks through the bank (Block & Hirt, 2004).
Companies can use this to their advantage. If $500 in checks was written to suppliers and $800 was deposited in checks received by the company, possibly only $300 of the checks written by the company had cleared and $700 of the received checks had cleared. This would give the firm an extra $300 in available short term funds.
A company can manage their cash by improving collections by using collection centers or lockbox systems. Collection centers help companies process checks quicker. Lockboxes process checks quickly and at a lower cost.
The slowing of disbursements is not uncommon in cash management (Block & Hirt, 2004). Banks assist firms in controlling disbursements. This allows the firm to time their payments so that they hold their cash as long as possible.
The costs of a comprehensive cash management program can be substantial. The use of disbursement centers and remote collection can be expensive; along with the banks that may charge a fee or require the maintenance of adequate deposit balances. The use of a lockbox system may bring costs down, but overall the costs are significant. The firm needs to run a cost-benefit analysis to compare the expenses of the cash management program to the benefits that will be accrued by having a comprehensive program.
Electronic funds transfer is the process of moving funds from one computer terminal to another without the use of a check. The techniques used to delay payments and floats are being reduced due to technology and the technique of electronic funds transfer (Block & Hirt, 2004). Automated clearing houses (ACH) transfer information between one financial institution to another, and from account to account via computer. Direct deposit of checks is one of the most popular uses of ACHs. As stated by Block & Hirt (2004), “ It is estimated by Elliot C. McEntee, president and CEO of NACHA, that Americans save more that $1 billion in postage costs and late fees in 2003 by using direct payments, while companies and government agencies saved billions of dollars” (p. 182).
Corporations that do business in many nations can shift money from country to country. Interest rates are different in all countries; therefore, a company may prefer to take advantage of high interest rates available in a particular country. Financial institutions and businesses can now make multicurrency payments via computer.
According to Investopedia (2009), “Marketable Securities are very liquid securities that can be converted into cash quickly at a reasonable price. Marketable securities are very liquid as they tend to have maturities of less than one year. Furthermore, the rate at which these securities can be bought or sold has little effect on their prices” (Marketable Securities, ¶ 1). Marketable securities consist of: treasury bills, treasury notes, treasury inflation protection securities, federal agency securities, certificate of deposit, commercial paper, banker’s acceptance, Eurodollar certificate of deposit, passbook savings account, and money market accounts.
Firms will maintain levels of marketable securities to ensure that they are able to replenish cash balances quickly and to obtain higher returns than is possible by maintaining cash. Companies will hold securities with very little risk for their immediate cash needs. Highly liquid debt instruments such as commercial paper (short-term marketable promissory notes issued by
financial institutions and other corporations), bankers’ acceptances (drafts issued and accepted by
banks often used in international trade) and various government securities such as Treasury Bills
and agency notes are frequently maintained in marketable security accounts. Other highly liquid instruments such as money market funds and certificates of deposit, are also maintained as marketable securities
Management of Accounts Receivable
Firms maintain accounts receivables to stimulate sales. Many clients prefer to make purchases on credit. A liberal accounts receivable policy tends to result in increased sales levels. That is, firms may stimulate their sales levels by relaxing their terms of credit. However, maintenance of accounts receivable represents an opportunity cost to the firm in terms of forgone returns on other assets. Furthermore, accounts receivable represent potential bad debt losses to the firm. The firm must find the appropriate balance of these costs relative to the benefits associated with accounts receivable. This appropriate or optimal balance occurs when the marginal costs of credit policy exactly offset its marginal benefits.
Many firms will establish a credit period for their customers but will offer discounts to encourage them to pay early. For example, the terms “2/10, net 30” state that the bill is due in full within 30 days but the customer is offered a 2% discount if it pays within 10 days. Longer credit periods or more liberal credit terms are likely to stimulate sales, but at the same time, the firm forgoes the use of its money for a greater length of time and increases the potential for bad debt losses. Increasing the percentage discount will help speed the collection process, but at the expense of total cash flows from sales. Many firms will ease credit terms for products that take longer to sell. Such low turnover goods are more likely to be tied up longer as inventory; using liberal credit terms to defer cash receipts from their sale is less costly if the alternative is higher inventory levels. Similarly, more competitive markets for the firm’s products may also encourage more liberal credit terms since such terms may enhance the firm’s ability to compete.
Before extending credit, the firm will probably wish to investigate the credit-worthiness of the customer. This investigation may simply focus on the firm’s customer’s credit history with the firm or may include contacting various credit reporting agencies (such as Dun and Bradstreet), checking with the customer’s bank and other suppliers of credit and examining the customer’s financial statements and operations. The financial statement analysis will probably require the use of financial ratios, particularly those reflecting the firm’s liquidity position.
Inventory falls into three categories raw material, work in progress, and finished goods. According to Block & Hirt (2004), “All of these forms need to be financed and their efficient management can increase a firm’s profitability” (p.194). The firm needs to decide if they are going to follow a level or seasonal production plan. It also must take into account inflation and deflation. It must hedge by using a futures contract to sell at a certain price in the near future. The firm must develop an inventory model. It can do this by first assessing various costs, including those resulting from ordering inventories and those associated with carrying inventory. Order costs will include all expenses resulting from obtaining inventory such as administrative ordering costs incurred by the firm, fees to agents, and in some cases, shipping costs. Inventory carry costs will include storage expenses such as warehouse heating and lighting costs. With this information the firm can then determine the economic ordering quantity (EOQ). This is the most advantageous amount for the firm to order each time. The equation is: .
S = Total Sales in units, O = Ordering cost for each order, C = Carrying cost per unit in dollars.
If an entity runs out stock it could lose sales to a competitor. This may cause a firm to hold what is called safety stock. Even though the company will determine the optimum order quantity, they cannot predict the delivery schedules for suppliers or the fact that there will be stock to purchase when the old inventory reaches zero. This safety stock will help reduce these risks. “The amount of safety stock that a firm carries is likely to be influenced by the predictability of inventory usage and the time period necessary to fill inventory orders” (Block & Hirt, 2004, p. 199).
Just-in-time inventory (JIT) is a way to keep inventory costs down. This concept started in Japan with Toyota. Three components must be present: quality production with customer satisfaction; close ties between suppliers, manufacturers, and customers; and, low inventory. The benefits of JIT include cost savings from lower levels of inventory and reduced financing costs.
Methods of Short-Term Financing
Short-term financing opportunities are available in a variety of ways to companies. Most of short-term transactions covered by financing are for periods of 180 days or less. Short-term financing is required when the need to increase inventory is present. Inventory is then converted to sales. When extended payment terms are given to these sales, accounts receivable are created. Inventory and accounts receivable are short-term and provide a collateral base for a lender to provide financing. A company may need financing when the inventory and accounts receivable grow at a fast pace as a result of continually increasing sales; this creates the need for funds to support the increase in the accounts that are growing at a faster rate than the accounts receivables can be converted to cash. The many different types of short-term financing will be explored throughout the rest of the paper.
According to Block & Hirt (2004), “The largest provider of short-term credit is usually at the firm’s doorstep – the manufacturer or seller of goods and services (p. 211). A firm will use its accounts payable to fund future operations, this is called trade credit. The usual payment period for trade credit is 30 to 60 days. Many companies allow a cash discount to encourage early payment. A 2/10, net 30 cash discount means 2% will be deducted from the price if the payment is remitted in 10 days. Failure to do so will result in the full amount being due in 30 days.
“Banks can provide financing for seasonal needs, product line expansion, and long-term growth” (Block & Hirt, 2004, p. 212). Because of bank deregulation an entity now has access to many different kinds of banks that can be used for short-term financing; commercial banks, savings and loans, credit unions, brokerage houses, and new companies offering financial services are just a few options that firms can choose from.
When using a bank for short term financing prime rates need to be considered. The higher the customer’s credit risk, the higher of an interest rate will be charged by the bank. Since London is the center of the Eurodollar deposits, United States businesses can borrow from London banks quite easily. The London Interbank Offered Rate (LIBOR) is usually lower than the prime rate in the U.S.; therefore, companies can borrow from the London banks at a lower interest rate than they would get in the U.S.
Many banks require a compensating balance when money is borrowed. This must be looked at closely by the financial manager. This requires the company to borrow more than is needed because a portion of the loan will be kept in an account with the bank.
When a company takes a term loan or secures a loan with interest and a compensating balance a cost-benefit analysis needs to be done by the financial manager. The cost for borrowing money these ways can be high. The amount of money the company might expend on securing short-term financing through a bank might not be a financially smart decision.
A short-term promissory note issued to the public in minimum units of $25,000 is called commercial paper (Block & Hirt, 2004). Commercial paper is broken down into two categories: finance paper and dealer paper. Finance paper is sold directly from the finance company to the lender. Dealer paper is sold by small companies such as utility firms, industrial companies, and financial firms. The commercial paper is then distributed by intermediate dealers for the small companies. Financial managers like using commercial paper for their short-term financing needs because they have no compensating balances and the charged interest rates are usually below the prime interest rate. According to Block & Hirt (2004), “Although the funds provides through the issuance of commercial paper are cheaper than bank loans, they are also less predictable” (p. 221).
Accounts Receivable Financing
If a borrower’s credit rating is too low or its need for funds too large, the lending institution might require that certain assets be used as collateral. Accounts receivable financing is a way for the company to get the funding. A company can either pledge the accounts receivable or factor them. Pledging accounts receivables means the financing company will lend 60% – 90% of the value of the acceptable collateral. If the borrower defaults on the loan the lender will have full recourse against borrower. Interest rates are generally well above prime for this type of loan.
Factoring the accounts receivables means that the company sold those accounts directly to the lender. The customer’s will now make their payments directly to the lending company. The borrowing firm will pay the factoring firm a commission fee as well a lending rate for assuming the risk of the accounts receivable.
Entities may also borrow against their inventory to gain funds. According to Block & Hirt (2004), “The extent to which inventory financing may be employed is based on the marketability of the pledged goods, their associated price stability, and the perishability of the product“(p. 226). Borrowing against inventory can be done three ways: blanket inventory liens, trust receipts, and warehousing.
Blanket inventory liens are the simplest way to borrow against the inventory. There is no physical transfer of the merchandise. The lending company has a general claim against the inventory.
Trust receipts are instruments acknowledging that the borrower holds the inventory and proceeds from the sales in trust for the lender (Bloch & Hirt, 2004). Each piece of inventory is marked with a serial number; when it is sold, the proceeds are given to the lender and the trust receipt is destroyed. This gives more control to the lender than blanket inventory does but the borrower still has physical control of the inventory.
Warehousing is when the inventory is physically stored in a warehouse under the direction of a third party warehousing company. The goods can only be moved with the lender’s approval. If the inventory is stored in the third party warehousing company’s warehouse it is called public warehousing. Field warehousing is when the inventory is kept in the borrower’s warehouse but is controlled by a third party warehousing company.
Cash flow management is absolutely critical to the financial survival of a firm. A shortage of cash may result in a firm that shows a profit on its income statement but is bankrupted by being unable to meet its financial obligations. Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company’s level of liquidity, its management of cash balance, and its short-term investment strategies. In some ways, managing cash flow is the most important job of business managers. If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. According to Answers.com (2009), “Insolvency is the primary reason firms go bankrupt” (Cash Management, ¶ 3). Obviously, the possibility of such a consequence should encourage companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy; it improves the profitability and reduces the risk to which the firm is exposed.
Answers.com. (2009). Cash Management. Retrieved July 11, 2009, from
Block, S., B., & Hirt, G., A. (2004). Foundations of Financial Management, 11/e.
Retrieved June 1, 2009, from University of Phoenix eBook Collection on the World Wide Web: http://www.apollolibrary.com.
Investopedia. (2009). Marketable Securities. Retrieved July 11, 2009, from