CASH MANAGEMENT

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Photo by: Marc Dietrich

Cash management is a broad area having to do with the collection, concentration, and disbursement of cash including measuring the level of liquidity, managing the cash balance, and short-term investments.

If at any time, because of a lack of cash, a corporation fails to pay an obligation when it is due, the corporation is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such dire consequence compels companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk the firm is exposed to.

COLLECTION AND DISBURSEMENT

Cash collection systems aim to reduce the time it takes to collect the cash that is owed to the firm (for example, from its customers). The time delays are categorized as mail float, processing float, and bank float. Obviously, an envelope mailed by a customer containing payment to a supplier firm does not arrive at its destination instantly. Likewise, the moment the firm receives payment it is not deposited in its bank account. And finally, when the payment is deposited in the bank account oftentimes the bank does not give immediate availability to the funds. These three "floats" are time delays that add up quickly, requiring the firm in the meantime to find cash elsewhere to pay its bills. Cash management attempts to decrease the time delays in collection at the lowest cost. A collection receipt point closer to the customer, such as a lock box, with an outside third-party vendor to receive, process, and deposit the payment (check) will speed up the collection. For example, if a firm collects $10 million each day and can permanently speed up collections by five days, at 6 percent interest rates, then annual before-tax profits would increase by $3 million. The techniques to analyze this case would utilize data involving where the customers were; how much and how often they pay; the bank they remit checks from; the collection sites the firm has (their own or a third-party vendor); the costs of processing payments; the time delays involved for mail, processing, and banking; and the prevailing interest rate that can be earned on excess funds.

Once the money has been collected, most firms then proceed to concentrate the cash into one center. The rationale for such a move is to have complete control of the cash and to provide greater investment opportunities with larger sums of money available as surplus. There are numerous mechanisms that can be employed to concentrate the cash, such as wire transfers, automated clearinghouse transfers, and checks. The tradeoff is between cost and time.

Disbursement is the opposite of collection. Here, the firm strives to slow down payments. It wants to increase mail delays and bank delays, and it has no control over processing delay.

OPTIMAL CASH BALANCE

Another aspect of cash management is knowing the optimal cash balance. There are a number of methods that try to determine the magical cash balance, which should be targeted so that costs are minimized and yet adequate liquidity exists to ensure bills are paid on time (hopefully with something left over for emergency purposes). One of the first steps in managing the cash balance is measuring liquidity. There are numerous ways to measure this, including: cash to total assets ratio, current ratio (current assets divided by current liabilities), quick ratio (current assets less inventory, divided by current liabilities), and the net liquid balance (cash plus marketable securities less short-term notes payable, divided by total assets). The higher the number generated by the liquidity measure, the greater the liquidity and vice versa. There is a trade off, however, between liquidity and profitability that discourages firms from having excessive liquidity.

CASH MANAGEMENT MODELS

To help manage cash on a day-to-day basis in actual dollars and cents, there are a number of cash management models. These include the Baumol Model, Miller-Orr Model, and the Stone Model.

BAUMOL MODEL.

The Baumol Model is similar to the Economic Order Quantity (EOQ) Model. Mathematically it is:

where C = the optimal amount of cash to be acquired when reaching a threshold balance,
F = the fixed cost of acquiring the cash C amount,
S = the amount of cash spent during a time interval,
i = the interest rate expressed in the same time interval as S

One shortcoming of this model is that it accommodates only a net cash outflow situation as opposed to both inflows and outflows. Also, the cash outflow is at a constant rate, with no variation.

MILLER-ORR MODEL.

The Miller-Orr Model rectifies some of the deficiencies of the Baumol Model by accommodating a fluctuating cash flow stream that can be either inflow or outflow. The Miller-Orr Model has an upper limit U and lower limit L

When there is too much cash and U is reached, cash is taken out (to buy short-term securities to earn interest) such that the cash balance goes to a return (R) point. Otherwise, if there is too little cash and L is reached, cash is deposited (from the short-term investments) to replenish the balance to R. The equations of the Miller-Orr Model are:

where R = the return point,
f = the fixed cost for each transaction to withdraw or deposit cash,
s ² = the variance of the cash flows,
i = the interest rate per same time period as s ² ,
U = the upper limit

L is determined by other means, for example, compensating balance requirement, minimum balance to avoid bank service charges on checking account, or zero.

STONE MODEL.

The Stone Model is somewhat similar to the Miller-Orr Model insofar as it uses control limits. It incorporates, however, a look-ahead forecast of cash flows when an upper or lower limit is hit to take into account the possibility that the surplus or deficit of cash may naturally correct itself. If the upper control limit is reached, but is to be followed by cash outflow days that would bring the cash balance down to an acceptable level, then nothing is done. If instead the surplus cash would substantially remain that way, then cash is withdrawn to get the cash balance to a predetermined return point. Of course, if cash were in short supply and the lower control limit was reached, the opposite would apply. In this way the Stone Model takes into consideration the cash flow forecast.

The goals of these models are to ensure adequate amounts of cash on hand for bill payments, to minimize transaction costs in acquiring cash when deficiencies exist, and to dispose of cash when a surplus arises. These models assume some cash flow pattern as a given, leaving the task of cash collection, concentration, and disbursement to other methods.

SHORT-TERM INVESTMENT DECISIONS

A key cash management problem (including how much money and for how long) concerns in which money market instruments should the temporary excess funds be placed. This short-term investment decision necessitates the analysis of return (need to annualize returns in order to compare) and liquidity. Only short-term investments meet the liquidity test, as long-duration instruments expose the investor to too much interest rate risk. In addition, federal government obligations are popular due to the absence of default risk and ease of resale in the secondary market. Nonetheless, there are numerous money market securities available with varying characteristics from many types of issuers.

Cash management is evolving with the increasing acceptance and use of electronic payments, such as debit cards. Shifting from paper-based payments to electronic transfers reduces the uncertainty in cash flow forecasting. The change in form of payment decreases both float and per item transaction costs. Stumbling blocks to the complete switchover to electronic payments include the initial equipment investment for businesses and resistance by consumers who still prefer checks. Nevertheless, the use of electronic versus paper payments is gaining, affecting the importance of current cash management techniques.