Cash and Marketable Securities Management

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FINANCIAL MANAGEMENT

CASH AND MARKETABLE SECURITIES MANAGEMENT

Cash conversion cycle (CCC)


• measures the length of time required for a company to convert cash invested in its operations to cash received
as a result of its operations.
• The length of time funds is tied up in working capital, or the length of time between paying for working capital
and collecting cash from the sale of the working capital.
Inventory Conversion Period (ICP) or Average Age of inventory
• The average time required to convert raw materials into finished goods and then to sell them.
Average Collection Period (ACP) or Average age of receivable
• The average length of time required to convert the firm’s receivables into cash, that is, to collect cash following
a sale.
Payables Deferral Period (PDP) or Average Payable Period
• The average length of time between the purchase of materials and labor and the payment of cash for them.
Operating Cycle (OC)
• time from the beginning of the production process to collection of cash from the sale of the finished product
• It is measured in elapsed time by summing the Inventory Conversion Period (ICP) and the Average Collection
Period (ACP)

Calculating the Operating Cycle (OC)


𝑂𝐶 = 𝐼𝐶𝑃 + 𝐴𝐶𝑃

Note: Accounts payable reduce the number of days a firm’s resources are tied up in the operating cycle. The Payables
Deferral Period (PDP) is the time it takes to pay the accounts payable, measured in days. The operating cycle less the
average payment period yields the cash conversion cycle.

Calculating the Cash conversion cycle (CCC)


𝐶𝐶𝐶 = 𝐼𝐶𝑃 + 𝐴𝐶𝑃 − 𝑃𝐷𝑃
𝐶𝐶𝐶 = 𝑂𝐶 − 𝑃𝐷𝑃

Illustration of Cash Conversion Cycle: Relationship of Inventory, Receivables, and Payable Days

Strategies for Managing the Cash Conversion Cycle


Firms typically set a target Cash conversion cycle and monitor or benchmark its actual performance with it. The
goal is to minimize the length of the cash conversion cycle. This goal can be achieved with the following:
a. Collect accounts receivable as quickly as possible
b. Increase the Turnover of inventory
c. Manage mail, processing, and clearing time: (1) to reduce them when collecting from customers and (2) to
increase them when paying suppliers.
d. Pay accounts payable as slowly as possible without damaging the firm’s credit rating
PROBLEMS
1. Media Co. has an inventory conversion period of 50 days, a receivable conversion period of 25 das, and a
payment cycle of 20 days. Compute:
a. Operating Cycle 75 days
b. Cash Conversion cycle 55 days

2. Amidamaru Co.’s inventory is worth 10,000 and its receivable from customer, 4,000. Its daily sales averages 100.
Its daily cost of goods sold is 50. Also, Amidamaru Co. owes 3,000 to its suppliers. An average of 50 worth of
purchases is made daily. Compute:
a. Inventory Conversion Period/ Days inventory 200 days
b. Receivable Collection Period/ Days receivable 40 days
c. Payment Cycle/ Days payable 60 days
d. Cash Conversion Cycle 180 days

Optimal cash balance


The Baumol model, also known as the Baumol-Allais-Tobin (BAT) model, is a cash management model. In 1952,
Wiliam Baumol presented the idea of managing the surplus of funds through the optimal use of stock supply quantities.
He came to the conclusion that money can also be treated as a specific type of stock, one that is necessary when doing
business. As per the model, cash and inventory management problems are one and the same – they are similar with the
next lesson on Inventory Management (Economic Order Quantity or EOQ)

Baumol model of cash management


• helps in determining a firm's optimum cash balance under certainty.
• enables companies to find out their desirable level of cash balance under certainty.
• relies on the tradeoff between the liquidity provided by holding money and the interest foregone by holding
one's assets in the form of non-interest-bearing money

Graph and Assumptions of Baumol Model:

Restrictions or limitations on the Baumol model


• the company has to use up the stock evenly in order for the model to work.
• in the enterprise it is difficult to determine the precise demand for financial resources, also the expenses
incurred by the company do not spread equally over the entire period
• in the application of the model is also a time-varying transaction commission, which can often be negotiated
and depends on the size of the transaction and the maturity date.
• the interest rate on the current account is variable over time, as is the yield on treasury bills, which additionally
depends on the maturity of separate series.
Baumol Formula:
2𝐷𝑇!
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝑇𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑆𝑖𝑧𝑒 = :
𝑂!
Where:
D = Annual Cash Demand or Requirement
Tc = Transaction Cost (Fixed cost of cash transfer)
Oc = Opportunity Cost (alternative cost of maintaining cash)

Note: Other pertinent formula under Baumol Model and Cash Management, especially if the firm has a cash buffer, is
presented in separate solution of the problem below.

PROBLEMS
Dursley’s evaluation of its cash outlay required indicates that it needs 20,000 for the year. Regardless of the amount. It
incurs 18.75 to convert marketable securities to cash. The marketable securities earn an annual rate of 7.5%.

Case 1: Dursley does not maintain buffer cash


1. How much is the optimal transaction size? 100,000
2. How much is the average cash balance? 50,000
3. How much is the annual holding cost as a result of keeping cash in bank (instead of putting it in
marketable securities)? 3,750
4. How many transactions should be there in a year? 200
5. How much transaction cost are incurred throughout the year? 3,750
6. How much is the total annual cost of cash? 7,500

Case 2: Dursley maintain buffer cash of 20,000 all throughout the year
1. How much is the optimal transaction size? 100,000
2. How much is the average cash balance? 70,000
3. How much is the annual holding cost as a result of keeping cash in bank (instead of putting it in
marketable securities)? 5,250
4. How many transactions should be there in a year? 200
5. How much transaction cost are incurred throughout the year? 3,750
6. How much is the total annual cost of cash? 9,000

Collection and disbursement float: Cash management system


Payables Deferral Period (PDP) or Average Payable Period also has two parts:
a. the time from purchase of goods on account until the firm mails its payment; and
b. the receipt, processing, and collection time required by the firm’s suppliers.

Float
• funds that have been sent by the payer but are not yet usable funds to the payee
• critical in the cash conversion cycle because its presence lengthens both the firm’s average collection period and
its average payment period.
• Three components or parts:
o mail float - the time delay between when payment is placed in the mail and when it is received.
o processing float - the time between receipt of the payment and its deposit into the firm’s account.
o clearing float - the time between deposit of the payment and when spendable funds become available
to the firm. This is attributable to the length of time required to clear checks within the banking system.

Popular techniques for managing the component parts of float:


A. Speeding Up Collections – reduces customer collection float time and thus reduces the firm’s average collection
period. A popular technique for speeding up collections is a lockbox system.
Lockbox system
• A collection procedure in which customers mail payments to a post office box that is emptied regularly
by the firm’s bank, which processes the payments and deposits them in the firm’s account. This system
speeds up collection time by reducing processing time as well as mail and clearing time.
• Lockbox systems are commonly used by large firms whose customers are geographically dispersed.
• A collection procedure in which customers mail payments to a post office box that is emptied regularly
by the firm’s bank, which processes the payments and deposits them in the firm’s account. This system
speeds up collection time by reducing processing time as well as mail and clearing time.

B. Slowing Down Payments


Controlled disbursing
• The strategic use of mailing points and bank accounts to lengthen mail float and clearing float,
respectively.
• Firms must use this approach carefully, though, because longer payment periods may strain supplier
relations.

Pertinent Formulas:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡 𝐹𝑙𝑜𝑎𝑡 = (𝑀𝑎𝑖𝑙 𝑇𝑖𝑚𝑒 + 𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 𝑇𝑖𝑚𝑒 + 𝐶𝑙𝑒𝑎𝑟𝑛𝑔 𝑇𝑖𝑚𝑒) 𝑥 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝐹𝑙𝑜𝑎𝑡 = (𝑀𝑎𝑖𝑙 𝑇𝑖𝑚𝑒 + 𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑖𝑛𝑔 𝑇𝑖𝑚𝑒 + 𝐶𝑙𝑒𝑎𝑟𝑛𝑔 𝑇𝑖𝑚𝑒) 𝑥 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛

𝑁𝑒𝑡 𝐹𝑙𝑜𝑎𝑡 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐷𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡 𝐹𝑙𝑜𝑎𝑡 − 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝐹𝑙𝑜𝑎𝑡
If Positive = “Net Positive Float”
If Negative = “Net Negative Float”

PROBLEMS
1. The following data pertains to Asakura Corp.’s:
Asakura Corp.’s payment to suppliers Asakura Corp.’s collection from customers
(in number of days) (in number of days)
Mail time 4 Mail time 3
Processing Delay 3 Processing Delay 2
Clearing Delay 1 Clearing Delay 1

Asakura Corp.’s average daily payment is P1,000 meanwhile daily collection average P1,500.
a. How much is the average daily disbursement float? 8,000
b. How much is the average daily collection float? 9,000
c. How much is the net float? (1,000)

2. Smart Enterprise supplies components to auto repair stations. These stations send their checks via remittance
firms. On average, Smart receives the checks 2 days after the date they were sent. Smart processes the checks
after 2 days, after which they are subsequently deposited to the bank. The bank cleats the check within 24
hours. Average daily collection is P40,000.
a. How much is the average daily collection float? 200,000
b. If the cash can be readily invested in instrument earning 5%, how much is the daily cost of the float?
27.78
c. If Smart Enterprise can process checks within a day and deposit the same immediately, how much can it
save in a year? 2,000 savings

3. Joy Inc. pays its purchases from remote disbursement centers. This strategy delays the clearing of checks.
Disbursement time increases by 2 days due to this practice. Cash freed from this scheme are placed in
instruments yielding 10%. Average daily disbursement is P50,000.
a. How much will be saved each year in implementing this strategy? 10,000
Other topics under Cash Management
Cash concentration
• The process used by the firm to bring lockbox and other deposits together into one bank, often called the
concentration bank.
• three main advantages
a. it creates a large pool of funds for use in making short-term cash investments. Because there is a fixed-
cost component in the transaction cost associated with such investments, investing a single pool of funds
reduces the firm’s transaction costs.
b. concentrating the firm’s cash in one account improves the tracking and internal control of the firm’s cash.
c. having one concentration bank enables the firm to implement payment strategies that reduce idle cash
balances
Wire transfer
• An electronic communication that, via bookkeeping entries, removes funds from the payer’s bank and deposits
them in the payee’s bank.
Zero-balance account (ZBA)
• A disbursement account that always has an end-of-day balance of zero because the firm deposits money to
cover checks drawn on the account only as they are presented for payment each day.

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