9. Cash Management Flashcards
What is cash management concerned with?
Cash management is concerned with how to minimise cash balances by collecting and disbursing cash effectively.
What are the two main reasons for a company to hold cash?
- To satisfy the transaction motive.
- Compensating balances.
What is the transaction motive?
The desire to hold money for the purpose of making transactions such as buying goods and services. Transaction-related needs come from normal disbursement and collection activities of the firm.
What does the disbursement of cash in a company include?
The disbursement of cash (cash outflows) in a company includes:
- the payment of wages and salaries
- trade debts
- taxes
- dividends.
Where is the cash in a company collected from?
Cash is collected by a company from sales from operations, sales of assets, and new financing.
Why does a company need to hold cash to satisfy the transaction motive?
The cash inflows (collections) and outflows (disbursements) are not perfectly synchronised, and some level of cash holdings is necessary as a buffer for precautionary purposes. If the firm maintains too small a cash balance, it may run out of cash. If so, it must sell marketable securities or borrow. Selling marketable securities and borrowing involve trading costs.
What is a compensating balance?
A compensating balance is a minimum amount of money a borrower must keep in a bank account as collateral for a loan or line of credit (this is more common with corporate rather than individual loans). Agreeing to a compensating balance allows a company to borrow money at a favourable rate of interest. The borrower is not able to use the money in the compensating balance but must disclose it in their financial statements. The cash balance for most firms can be thought of as consisting of transaction balances and compensating balances.
How does a company determine its target cash balance?
The firm must weight the benefits of holding cash against the costs. It is generally a good idea for firms to figure out first how much cash to hold to satisfy transaction needs. Next, the firm must consider compensating balance requirements, which will impose a lower limit on the amount of the firm’s cash holdings.
The target cash balance involves a trade-off between the opportunity costs of holding too much cash and the trading costs of holding too little. If a firm tries to keep its cash holdings too lower, it will find itself selling marketable securities (and perhaps later buying marketable securities to replace those sold) more frequently than if the cash balance was higher. Thus, trading costs will tend to fall as the cash balance becomes larger.
What are the limitations of the Baumol model?
- The model assumes the firm has a constant disbursement rate. It assumes discrete, certain cash flows.
- The model assumes there are no cash receipts (i.e., no cash inflows) during the projected period.
- No safety stock is allowed. Firms will probably want to hold a safety stock of cash designed to reduce the possibility of a cash shortage. However, to the extent that firms can sell marketable securities or borrow in a few hours, the need for a safety stock is minimal.
What are the advantages of the Miller-Orr model?
The Miller-Orr model:
- Plans for precautionary needs for cash by including a minimum balance (which can be non-zero).
- Accounts for uncertainty in cash flow fluctuation by including the standard deviation of the cash flow series.
What must a manager do to use the Miller-Orr model?
- Set the lower limit for the cash balance. This lower limit can be related to a minimum safety margin decided on by management.
- Estimate the standard deviation of daily cash flows.
- Determine the interest rate.
- Estimate the trading costs of buying and selling marketable securities.
What are the weaknesses of both the Baumol and Miller-Orr cash management models?
Other factors than those considered in Baumol and Miller-Orr models influence the target cash balance. We assumed that the firm would raise cash by selling securities but it could also raise cash by borrowing. This influences the target cash balance because:
- Borrowing is likely to be more expensive than selling marketable securities.
- The need to borrow will depend upon how unpredictable cash flows are likely to be.
More firms will tend to hold cash greater than the prediction of the models because of:
- Required compensating balances held at the bank for banking services.
- Large corporations have thousands of accounts with many banks. Difficult to manage on a daily basis.
