Notesale: Turn your study into money

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Management of Cash
Cash includes currency, cheques, drafts, demand deposits as well as marketable securities and
demand deposits
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Cash is the most liquid and hence the most important current
asset since it can be used to make immediate payments
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On the other hand,
excessive liquidity may force a firm to loose on profitability since cash is a current asset and
current assets are idle assets-it does not earn any substantial return for the firm
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How do cash problems arise?
(i)
Making losses
(ii)
Inflation- during inflation, firms need high levels of cash to replace used up assets and
worn out assets
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(iv)
Seasonal loss- When a firm has seasonal or cyclical sales, it may have cash flow
difficulties at certain times of the year, when (i) Cash inflows are low but ii) cash
outflows are high perhaps coz the business is building up its stocks for the next peak
sales period
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a) Repayment of loan capital on maturity of the debt
b) The purchase of exceptionally expensive item
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5 Methods of easing cash shortages
(i)
Postponing capital expenditure
Some capital expenditure items are more important and urgent than others
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However, some capital expenditure is routine and might
be postponable without serious consequences
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g routine replacement of motor
vehicles
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g
press debtors for earlier payment (however this may lead to loss of goodwill and
problems with customers)
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(iii)
Reversing past investment decision by selling off assets previous acquired
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(iv)
Negotiating a reduction in cash outflow, so as to postpone/even reduce payment
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Here, we begin by demonstrating the calculation and application of the cash
conversion cycle
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The operating cycle encompasses two
major short-term asset categories
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It is measured in
elapsed time by summing the average age of inventory (AAI) and the average collection
period (ACP)
OC= AAI + ACP

Eq
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Accounts
payable reduce the number of days a firm’s resources are tied up in the in the operating cycle
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The operating cycle less the average payment period is referred to as the cash
conversion cycle (CCC)
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The
formula for the cash conversion cycle is
CCC = OC- APP

Eq
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CCC = AAI + ACP – APP

Eq
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It changes the amount of resources tied up
in the day – to- day operation of the firm
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Negotiated liabilities carry an explicit cost, so the firm
benefits by minimizing their use in supporting operating assets
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This goal can be realized through application of the following strategies
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Turn over inventory as quick as possible without stock outs that result in lost sales
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Collect accounts receivable as quick as possible without losing sales from highpressure collection techniques
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Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers
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Pay accounts payable as slowly as possible without damaging the firm’s credit rating
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This may be done either through:
a) Concentration banking
b) Look-box system
Concentration Banking
Firms with regional sales outlets can designate certain of these as regional collection centre
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Funds in the local bank accounts in excess of a
specified limit are then transferred (by wire) to the firms major or concentration bank
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Lock- box system
In a lock- box system, the customer sends the payments to a post office box
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The bank opens
the payment envelope, deposits the cheques in the firms’ account and sends a deposits slip
indicating the payment received to the firm
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Illustration
Mvinyo co buys raw materials from suppliers that allow 2
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The raw materials
remain in the inventory for one month and it takes the company two months to produce the
goods
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Customers take on
average 1
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Required:
Calculate Mvinyos cash operating cycle
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Months
The average time inventory remains in inventory
Less time taken to pay suppliers
(2
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0

2
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5
2
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5

Goods
Purchased

3

4
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The credit term extended to the firm currently requires payment within thirty days of a
purchase while the firm currently requires its customers to pay within sixty days of a sale
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On average, 85 days elapse between the points a raw material is purchased and the point the
finished goods are sold
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e
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Cash Planning – cash budgeting for future requirements
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Cash flow management – matching timing of cash inflows & outflows
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Setting of optimum cash levels – Avoid excess cash or shortages
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Investing idle cash – investment vehicles depend on cash requirements i
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when will it be required?
Cash Planning (Cash budget)
The main purpose of preparing cash budgets are:(i)
To plan /forecast the organizations cash needs or cash surpluses over the budget
period
(ii)
To monitor actual cash inflows/outflows and balances
(iii)
To identify cash flow problems when they arise so as to identify their causes and take
measures to deal with them
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The firm should therefore hold the cash balance
that will enable it to meet its scheduled payments as they fall due to and provide a margin for
safety, there are several methods used to determine optimal cash
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These are;
a) Baumol model
Its application of EOQ Inventory model to cash management their assumptions are:
i
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The cash outflow from separations also occurs at a steady rate
iii
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 C=
Where
C = Optimal cash to be raised by borrowing/sale of marketable securities
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The interest rate a marketable securities is 12% every time the company sells marketable
securities, it incurs a cost of sh
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Required:
i
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ii
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iv
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C =

==

= SH
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13, 166
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Number of transfer = =

iii
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= 39
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a
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Find
the optimum cash it requires every time (i
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the maximum cash level of the firm)
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The model assumes a constant use of cash
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Generally, the cash outflows of the firm are not regular and hence this model
may not give correct results
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The transaction cost will also be difficult to measured since these depend upon
the type of investment as well as the maturity period
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Merton Miller & Daniel
Orr assumed that the distribution of daily net cash flows is approximately normal
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Thus the daily net cash follows a trendless random
walk
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When the cash balance reaches H,
H-Z shillings are transferred from cash to marketable securities
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The lower limit is usually set by management
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(buy securities)

Z

target cash bal, Z
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0
Time
Illustration
ZYZ: Management has set the minimum cash balance to be equal to sh10000
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2,500 and the interest rate in marketable
securities is 9% p
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the transaction cost for each sale or purchase of securities is sh
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31,933
c) Av
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However, these models are beyond the scope of this course
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Deposit with a bank or similar financial institution
ii
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Invest in the purchase of longer term debt instruments, which can be re-sold
second hand on a stock market when the company eventually needs the cash
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Invest in shares of listed company, which can be sold on the stock market
when the company eventually needs the cash
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With bank deposits (a) the risk of capital losses does not exist provides the bank remains
solvent
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These
debt instruments include
i) Certificate of deposits (CDS)
ii) Treasury bills
iii) Commercial papers etc
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The depositor will be another bank or a
large commercial organization CDs are negotiable and traded on the money markets and if a
CD holder wishes to obtain immediate cash, he can sell the CD on the market at any time
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Treasury Bills
Are issued weekly by the government to finance short term cash deficiencies in the
governments expenditure programme
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After which the holder is paid the
full value of the bill
The Treasury bill doesn’t pay interest but the purchase price of a treasury bill is less than
their face value i
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There is thus a n implied rate of interest in the price at which the bills are traded
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Treasury bills are shot-term obligations issued to cover current shortfalls and refinance
maturing government debts
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The treasury bills generally are 91-day,
182-day and 364-day in terms of maturity
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Characteristics of Treasury Bills
Default Risk Treasury bills are generally considered to be free of default risk because they
are obligations of the government of kenya
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Concern over the default risk of securities
other than Treasury securities typically increases in times of weak economic conditions, and
this tends to raise the differential between the rates on these securities and the rates on
Treasury bills of comparable maturity
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For example, banks use bills to make repurchase agreements free of reserve
requirements with businesses and state and local governments, and banks use bills to satisfy
pledging requirements on state and local
deposits
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And Treasury bills are always a permissible investment for state and
local governments, while many other types of money market instruments frequently are not
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Investors in Treasury bills have this ability because bills are a homogeneous instrument and
the bill market is highly organized and efficient
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In recent years the bid-asked spread on actively
traded bills has been 2 basis points or less, which is lower than for any other money market
instrument
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In 1990s the minimum denomination was Ksh
100,000
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Despite the increase in the minimum denomination of bills,
investors continued to shift substantial amounts of funds out of deposit institutions into the
bill market in periods of high interest rates such as 1973 and 1974
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Typically, it takes at least Ksh 100,000 to
purchase money market instruments such as CDs or commercial paper
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)
Re-Purchase Agreements
- Government security dealers may use repurchase agreements to increase their level of
liquidity
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- The investor receives a specified yield while holding the security
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Most re-purchase agreements are overnight although
once for as long as 6 months can be made
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Liquidity and cash flow management are key factors in successful operations
and of any organizations
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- It’s prepared to ensure that there will be just sufficient cash in hand to cope
adequately with budgeted activities
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- The main functions of a cash account
i
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To indicate when, where and how much cash will be needed and whether this is
permanent or temporary
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Preserve liquidity throughout the year
iv
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Guide management on financing capital expenses internally or externally
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Share capital
40,000
Machinery at cost
Reserves
20,000
less Accum
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Loan 15%
40,000
Stocks
Proposed dividends
1,000
Debtors
Overdraft
9,000

Shs
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In the subsequent month 20%
Payment for purchase is made in the month of purchase in order to take advantage of a 10%
prompt settlement discount calculated on the gross purchase figures shown above
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Depreciation of machinery is
calculated at the rate of 12% p
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on cost
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Expenses are paid for in the month in
which they are incurred
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Loan interest for
the three months will be paid in March
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ii) Prepare a forecast Trading, Profit and Loss Account for the period
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iv) Briefly explain why the change in Cash Balance between 1 January and 31 March is not
the same as the profit or loss figure for the period
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8 x 0
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8 x 0
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8 x 0

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