Cash Management Flashcards
What are the three motives for holding cash?
The following are the three motives for holding cash:
- Transactional (as a medium of exchange)
- Precautionary (to provide a reserve for contingencies)
- Speculative (to take advantage of unexpected opportunities)
What is the goal of cash management?
The goal of cash management is to determine and maintain the firm’s optimal cash balance
Since cash does not earn a return, only the amount needed to satisfy current obligations as they come due should be kept
Who should a firm’s optimal level of cash be determined?
The firm’s optimal level of cash should be determined by a cost-benefit analysis. The motives for holding cash must be balanced against the opportunity cost of missed investments in marketable securities
One approach is the economic order quantity (EOQ) model originally developed for inventory management. The model helps the firm determine the proper mix of cash and marketable securities
To apply the model, the firm must determine:
a. How much cash will be needed over a period
b. The cost per security transaction
c. The return that can be earned on marketable securities
How is forecasting future cash flows determined?
Managing cash flows begins with the cash budget. It states projected receipts and payments for the purpose of matching inflows and outflows
Cash receipts are based on projected sales, credit terms and estimated collection rates
Cash payments are based on budgeted purchases and total sales
The budget is for a specific period, but cash budgeting is an ongoing cumulative activity. It is re-evaluated constantly to ensure that all objectives are met
How the benefit of receiving cash early quantified?
Speeding up cash collections
The benefit of receiving cash earlier can be quantified:
= Daily cash receipts x Days of reduced float x Opportunity cost of funds
The period form when a payor mails a check until the funds are available in the payee’s bank is float. Firms use various strategies to decrease the float time for receipts (and to increase the float time for payments)
The product of the daily amount of receipts and the number of days of reduced float is the increase in the average cash balance. This amount is multiplied by an annual rate of return on short-term investments to arrive at the annual benefit
What is the most important means of speeding up cash collections?
A lockbox system is the most important means of speeding up cash receipts
Customers submit their payments to a mailbox rather than to the firm’s offices. Bank personnel remove the envelopes from the mailbox and deposit the checks to the firm’s account immediately. The remittance advices must then be transported to the firm for entry into the accounts receivable system. The bank generally charges a flat monthly fee for this service
When is the use of a lockbox network most appropriate?
For firms doing business nationwide, a lockbox network is appropriate. The country is dividend into regions according to customer population patterns. A lockbox arrangement is then established with a bank in each region
A firm with a lockbox network ordinarily engages in concentration banking. The regional banks that provide lockbox services automatically transfer their daily collections to the firm’s principal bank where they can be used for payments and short-term investments
What is a depository transfer check (DTC) system used?
A depository transfer check (DTC) system is used with a lockbox network. A DTC is a nonnegotiable instrument. It is drawn on the regional bank and made payable only to the firm’s account at the concentration bank
What is one way that speeds up cash management?
Transfer of funds by wire speeds up cash management. A wire transfer is any electronic funds transfer (EFT) by means of a two-way system (i.e. the Federal Reserve Wire Transfer System)
What is a draft?
A draft is a three-party instrument in which one person (the drawer) orders a second person (the drawee) to pay money to a third person (the payee)
What is a check?
A check is the most common form of draft. A check is an instrument payable on demand in which the drawee is a bank. Consequently, a draft can be used to delay the outflow of cash
A draft can be dated on the due date of an invoice and will not be processed by the drawee until that date. This practice eliminates writing a check earlier than the due date or using an EFT. Thus, the outflow is delayed until the check clears the drawee bank
How does a payable through draft (PTD) differs from a check?
A payable through draft (PTD) differs from a check in the following ways:
- It is NOT payable on demand
- The drawee is the payor (not a bank)
After the payee presents the PTD to a bank, the bank in turn presents it to the issuer. The issuer then must deposit sufficient funds to cover the PTD
Use of PTDs allows a firm to maintain lower cash balances. Disadvantages are that vendors prefer to receive an instrument that will be paid on demand and bank generally impose higher processing charges for PTDs
What is a zero-balance (ZBA) account and how do firms use them?
A zero-balance account (ZBA) has a balance of $0. At the end of each processing day, the bank transfers just enough from the firm’s master account to cover all checks presented against the ZBA that day
This practice allows the firm to maintain higher balances in the master account from which short-term investments can be made. The bank generally charges a fee for this service
What is payment (disbursement) float?
Payment (disbursement) float is the period form when the payor mails a check until the funds are subtracted from the payor’s account. To increase payment float, a firm may send checks to its vendors without being certain that it has sufficient funds to cover them all
For these situations, some banks offer overdraft protection. The bank guarantees (for a fee) to cover any shortage with a transfer from the firm’s master account
