Corporate Finance (MAIB FIN 101) Aug 2022

Cash and liquidity

management

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Cash and Liquidity Management
Reasons for Holding Cash

The speculative motive is the need to hold cash in order to be able to take advantage
of, for example, bargain purchases that might arise, attractive interest rates, and (in
the case of international firms) favorable exchange rate fluctuations.

The precautionary motive is the need for a safety supply to act as a financial reserve

Cash is needed to satisfy the transaction motive, the need to have cash on hand to
pay bills

Compensating balances are another reason to hold cash.

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Cash and Liquidity Management
COSTS OF HOLDING CASH

The opportunity cost of excess cash (held in currency or bank deposits) is the inter- est
income that could be earned in the next best use, such as an investment in marketable
securities.
cash balance must be maintained to provide the liquidity necessary for transaction needs—
paying bills
CASH MANAGEMENT VERSUS LIQUIDITY MANAGEMENT
distinguish between true cash management and a more general subject, liquidity
management.

financial managers frequently use the word in another way to describe a firm’s holdings of
cash along with its marketable securities, and marketable securities are sometimes called
cash equivalents or near-cash
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Cash and Liquidity Management
Understanding Float

The cash balance that a firm shows on its books is called the firm’s book, or ledger,
balance. The balance shown in its bank account as available to spend is called its
available, or collected, balance

The difference between the available balance and the ledger balance, called the float,
represents the net effect of checks in the process of clearing

Float = Firm’s available balance − Firm’s book balance

Disbursement float = Firm’s available balance − Firm’s book balance

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Cash and Liquidity Management
COLLECTION FLOAT AND NET FLOAT

Float = Firm’s available balance − Firm’s book balance

Collection float = Firm’s available balance − Firm’s book balance

In general, a firm’s payment (disbursement) activities generate disbursement float,

and its collection activities generate collection float. The net effect—that is, the sum of
the total collection and disbursement floats—is the net float.

fLOAT MANAGEMENT

Float management involves controlling the collection and disbursement of cash.

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Cash and Liquidity Management
Total collection or disbursement times can be broken down into three parts: Mailing
time, processing delay, and availability delay:
Mailing time is the part of the collection and disbursement process during which
checks are trapped in the postal system.
Processing delay is the time it takes the receiver of a check to process the payment
and deposit it in a bank for collection.
Availability delay refers to the time required to clear a check through the banking
system.

Average daily float = Average daily receipts × Weighted average delay

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Cash and Liquidity Management
ELECTRONIC DATA INTERCHANGE AND THE END OF FLOAT?
Electronic data interchange (EDI) is a general term that refers to the growing practice
of direct, electronic information exchange between all types of businesses.

One important use of EDI, often called financial EDI or FEDI, is to electronically transfer
financial information and funds between parties

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Cash and Liquidity Management

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Cash and Liquidity Management
Cash Collection and Concentration

LOCKBOXES

When a firm receives its payments by mail, it must decide where the checks will be
mailed and how the checks will be picked up and deposited. Careful selection of the
number and locations of collection points can greatly reduce collection times. Many
firms use special lockboxes to intercept payments and speed cash collection.

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Credit and Inventory Management
Credit and Receivables

From an accounting perspective, when credit is granted, an account receivable is cre-

ated. Such receivables include credit to other firms, called trade credit, and credit
granted to consumers, called consumer credit.

COMPONENTS OF CREDIT POLICY

terms of sale
The conditions under which a firm sells its goods and services for cash or credit.
credit analysis
The process of determining the probability that customers will not pay.
collection policy
The procedures followed by a firm in collecting accounts receivable

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Cash and Liquidity Management
THE CASH FLOWS FROM GRANTING CREDIT

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Cash and Liquidity Management
THE INVESTMENT IN RECEIVABLES

Accounts receivable = Average daily sales × ACP

Terms of the Sale

As we described previously, the terms of a sale are made up of three distinct
elements:
1. The period for which credit is granted (the credit period).
2. The cash discount and the discount period.
3. The type of credit instrument.

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Cash and Liquidity Management
THE CREDIT PERIOD
The length of time for which credit is granted.
invoice
A bill for goods or services provided by the seller to the purchaser.

Factors that influence the credit period

Perishability and collateral value
Consumer demand
Cost, profitability, and standardization:
Credit risk
Size of the account
Competition
Customer type

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Cash and Liquidity Management
CASH DISCOUNTS
A discount given to induce prompt payment. Also called a sales discount.

Cost of the Credit

Trade Discounts
The Cash Discount and the ACP

CREDIT INSTRUMENTS
open account ,
promissory note
commercial draft
sight draft
time draft
banker’s acceptance
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Cash and Liquidity Management
Analyzing Credit Policy
1. Revenue effects
2. Cost effects
3. The cost of debt
4. The probability of nonpayment
5. The cash discount

Optimal Credit Policy

THE TOTAL CREDIT COST CURVE

The carrying costs associated with granting credit come in three forms:
1. The required return on receivables.
2. The losses from bad debts.
3. The costs of managing credit and Corporate
creditFinance
collections
(MAIB FIN 101) Aug 2022 15
Cash and Liquidity Management

credit cost curve

A graphical
representation of the
sum of the carrying
costs and the
opportunity costs of a
credit policy.

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Cash and Liquidity Management
Credit Analysis

A One-Time Sale

If a company grants credit, and it spends v (the variable cost) this month and expects to collect (1 − π)P
next month. The NPV of granting credit is:

NPV = −v + (1 − π)P/(1 + R)

probability (π) can be interpreted as the percentage of new customers who will not pay

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Cash and Liquidity Management
Repeat Business

PV = (P − v)/R
The NPV of extending credit is:
NPV = −v + (1 − π)(P − v)/R

CREDIT INFORMATION
five Cs of credit are the basic factors to be evaluated:
Character: The customer’s willingness to meet credit obligations.
Capacity: The customer’s ability to meet credit obligations out of operating cash
flows.
Capital: The customer’s financial reserves.
Collateral: An asset pledged in the case of default.
Conditions: General economic conditions in the customer’s line of business.
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Cash and Liquidity Management
Collection Policy

MONITORING RECEIVABLES
Ageing Report

COLLECTION EFFORT
A firm usually goes through the following sequence of procedures for customers whose payments are overdue:
It sends out a delinquency letter informing the customer of the past-due status of the account.
It makes a telephone call to the customer.
It employs a collection agency.
It takes legal action against the customer.

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Inventory Management
THE FINANCIAL MANAGER AND INVENTORY POLICY

INVENTORY TYPES
raw material
work-in-progress
finished goods

INVENTORY COSTS
1. Storage and tracking costs.
2. Insurance and taxes.
3. Losses due to obsolescence, deterioration, or theft.
4. The opportunity cost of capital on the invested amount.

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Inventory Management
Inventory Management Techniques
THE ABC APPROACH
The underlying rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of
inventory value

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Inventory Management

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Inventory Management
Carrying Costs

Total carrying costs = Average inventory × Carrying cost per unit = (Q/2) × CC

Restocking Costs

Total restocking cost = Fixed cost per order × Number of orders = F × (T/Q)

Total costs = Carrying costs + Restocking costs = (Q/2) × CC + F × (T/Q)

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Inventory Management
we can find the minimum point by setting these costs equal to each other and solving for Q*

This reorder quantity, which

minimizes the total inventory
cost, is called the economic
order quantity (EOQ).

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Inventory Management
A company will wish to reorder before its inventory goes to zero for two reasons

First, by always having at least some inventory on hand, the firm minimizes the risk of a
stockout and the resulting losses of sales and customers.
Second, when a firm does reorder, there will be some time lag before the inventory
arrives

Safety Stocks A safety stock is the minimum level of inventory that a firm keeps on hand

Reorder Points To allow for delivery time, a firm will place orders before inventories
reach a critical level
The reorder points are the times at which the firm will actually place its inventory orders.

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Inventory Management
MANAGING DERIVED-DEMAND INVENTORIES

Materials requirements planning and just-in-time inventory management are two methods
for managing demand-dependent inventories.

Materials Requirements Planning

The basic idea behind MRP is that, once finished goods inventory levels are set, it is possible
to determine what levels of work-in-progress inven- tories must exist to meet the need for
finished goods. From there, it is possible to calculate the quantity of raw materials that must
be on hand.

Just-in-Time Inventory Just-in-time (JIT) inventory is a modern approach to man- aging

dependent inventories. The goal of JIT is to minimize such inventories, thereby max- imizing
turnover.
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