Chapter 15 Flashcards
Treasury management
the efficient management of liquidity and risk in a business including the management of funds (generated from internal and external sources), currencies and cash flow.
Advantages of centralized treasury management
Management by specialised staff with appropriate qualifications, expertise and experience.
Economies of scale (e.g. less staff required in total), as specialists are employed centrally, reducing duplication and maximising the use of skilled human resources and financial management systems.
Ability to use “pooling”, which is the netting of cash deficits against surpluses to save interest expense from short-term financing.
Increased negotiating power with banks as the amounts borrowed or deposited would be more substantial as a group.
More efficient foreign exchange risk management because the treasury department at the head office can find the group’s net position on each currency and then consider an external hedge on this balance.
Role of a treasurer
accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;
planning short-term borrowing when necessary;
planning investments of surpluses when necessary;
cost efficient cash transmission;
dealing with foreign currency issues;
optimising banking arrangements;
planning major finance-raising exercises; and
accounts receivable/accounts payable policies.
In addition, the treasurer is often involved in risk assessment and insurance.
Reasons for holding cash
Transactions motive, where cash is held to provide sufficient liquidity to meet current day-to-day financial obligations (e.g. payroll, the purchase of raw materials, etc).
Precautionary motive, where a cash reserve is held in order to give a cushion against unplanned expenditure, rather like a buffer/safety level of inventory. This reserve may be held in the form of “cash equivalents”, which are short-term, low risk, highly liquid investments (e.g. Treasury Bills).
Speculative motive, where cash is held to be able to quickly take advantage of investment opportunities that may arise (e.g. a “war chest” of cash ready to use if a suitable takeover target appears).
Why shouldn’t a firm hold excessive levels of cash
it is important that a firm does not hold excessive levels of cash as this leads to inefficiency. Cash balances belong to the shareholders who are expecting to receive significant return on their investment.
Any long-term surplus of cash should therefore be either reinvested into projects with a positive net present value or returned to shareholders via:
Dividends (regular or a special dividend); or
Share buy-back programmes.
What is the sensitivity analysis
assesses the effect if a key variable changes.
How can a sensitivity analysis deal with uncertainty in cash budgeting
by finding the effect of a change in:
payment patterns by credit customers (consider the worst-case scenario);
timing of other receipts (e.g. sale of non-current assets, rights issues, debt issues, etc);
materials costs (if prices are uncertain, consider a worst-case scenario);
other costs (e.g. labour, overheads) or timings of outflows (e.g. fixed overhead payments, dividends, capital expenditure);
interest rates where borrowings are at variable rates (forecast a worst-case scenario).
Alternative to sensitivity analysis
Simulation models
What do simulation models do
Simulation models can perform more dynamic analysis by incorporating possible interrelationships between variables (e.g. if interest rates rise there may be a fall in sales).
Unlike sensitivity analysis, simulation models (e.g. Monte Carlo) can simulate a range of possible future economic scenarios to estimate the probability of cash flows being higher/lower than expected. Through generating probabilities such models provide better analysis of cash flow risk.
Why do surplus funds arise
overfunding − proceeds which are not yet fully required may have already been received from a share/debt issue;
disposal of surplus assets or divisions; and/or
operating surpluses.
How should cash surpluses be invested
Long-term surpluses should be invested into positive NPV projects, or used to pay a dividend.
For short-term surpluses, the general rule is to invest in short-term, low-risk, highly liquid investments (e.g. Treasury bills).
Factors to take into consideration for investing surplus funds
Amount of funds available.
Required level of liquidity (i.e. how quickly the investment can be converted to cash).
Risk tolerance, which includes considering that shareholder funds should not be gambled with (placed in investments that are too risky). Default risk (i.e. the risk that the investment will not be repaid) should be considered.
The expected return on the proposed investment, with the return being limited because of the requirement to select low risk investments.
Money market deposits or bank deposits
these investments may have a notice period for withdrawals and therefore should only be used if there is high certainty of cash flows.
Treasury bills
two, three, and six-month UK government debt. These are very low risk and very liquid, but offer even lower returns. Treasury bills (T-bills) are short-term debt securities issued by the U.S. Department of the Treasury to help manage the government’s short-term funding needs. They are considered one of the safest investments since they are backed by the full faith and credit of the U.S. government.
Certificates of deposits
negotiable deposits issued by banks, with maturities from 28 days to five years. The holder can sell the certificate before its maturity date, so they are more liquid than money market deposits, but with lower returns.
