University of Economics and Human Sciences in

Warsaw
Cash management
CORPORATE FINANCE

RAFAŁ KUSY
Ph. D.
 Managing Accounts Payable
• Accounts payable arise from trade credit and are a spontaneous
form of credit.
• Credit terms may vary among industries and among companies,
although these tend to be similar within an industry because of
competitive pressures.
• Factors to consider:
• Company’s centralization of the financial function
• Number, size, and location of vendors
• Trade credit and the cost of alternative forms of short-term financing
• Control of disbursement float (i.e., amount paid but not yet credited to the
payer’s account)
• Inventory management system
• E-commerce and electronic data interchange (EDI), which is the customer-
to-business payment connection through the internet

2
 Reasons for Holding Cash
• Transactions motive:
• Transactions related needs come from normal disbursement and
collection activities of the firm.
• The disbursement of cash includes the payment of wages and salaries,
trade debts, taxes, and dividends.
• The cash inflows (collections) and outflows (disbursements) are not
perfectly synchronized, and some level of cash holdings is necessary to
serve as a buffer.
• Perfect liquidity is the characteristic of cash that allows it to satisfy the
transactions motive.
 Determining the Target Cash Balance
• The target cash balance involves a trade-off between the
opportunity costs of holding too much cash (lost interest) and
the trading costs of holding too little.
• If a firm tries to keep its cash holdings too low, it will find itself
selling marketable securities more frequently than if the cash
balance were higher.
• The trading costs will tend to fall as the cash balance becomes
larger.
• The opportunity costs of holding cash rise as the cash holdings
rise.
 Overview
ST fin’l planning = deals w/ short-lived assets and liabilities
(working capital management);

concerned with
1) size of investment in CA like cash, A/R, Inventory…a
tool is cash budget analysis and
2) how to finance ST assets…a tool is performing credit
analysis
 Managing WC involves determining:

• How much to invest in CA?

- CA vs. FA
- Nature of activities/programs
• In each CA?
- Cash, A/R, Inventory
- Cash Mgt
- A/R is Credit Mgt
- Inv = POM & Cash balance models
 Objectives of Public Money Managers

Bringing the entity’s cash resources within control

Achieving optimum conservation and utilization of
the funds
 Key areas of Public Cash Management

Organization
Collection and disbursement of funds
Netting of interagency payments
Investment of excess funds
Optimal level of cash balances
Cash planning and budgeting
Bank relations
 Treasury Management of Cash Balances

Operate with smaller amount of cash

Supervision is centralized
Better service from banks
Proper allocation of funds
 How much cash should a organization
keep on hand?

• Enough cash to make payments when needed.

(transactions motive)
• (Daily or Weekly Cash Budget helpful)

• Additional cash may be held for unexpected

requirements. (precautionary motive)
 The size of the minimum cash balance
depends on:
• How quickly and cheaply a organization can
raise cash when needed.

• How accurately managers can predict cash

requirements.
• (Cash Budget helpful)

• How much precautionary cash the managers

need for emergencies.
 The organization’s maximum cash
balance depends on:

• Available (short-term) investment opportunities

• e.g. money market funds, CDs, commercial paper
• Expected return on investment opportunities.
• e.g. If expected returns are high, organizations
should be quick to invest excess cash
• Transaction cost of withdrawing cash and
making an investment
• Demand for Cash for daily transactions
• (Cash Budget helpful)
 Costs of Holding Cash

Costs in dollars of
holding cash Trading costs increase when the firm
must sell securities to meet cash needs.
Total cost of holding cash

Opportunity
Costs
The investment income
foregone when holding cash.

Trading costs
C* Size of cash balance
 The Baumol Model

F = The fixed cost of selling securities to raise cash

T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the
interest rate. If we start with $C,
spend at a constant rate
each period and replace
C our cash with $C when
we run out of cash, our
average cash balance
C will be C .
2 2
The opportunity cost
of holding C is C  K
1 2 3 Time 2 2
 The Baumol Model

F = The fixed cost of selling securities to raise cash

T = The total amount of new cash needed
K = The opportunity cost of holding cash: this is the
interest rate.
As we transfer $C each
period we incur a trading
cost of F each period. If
C
we need T in total over the
planning period we will
C pay $F, T ÷ C times.
2

The trading cost is T F

1 2 3 Time C
 The Baumol Model
C T
Total cost   K   F
2 C C
Opportunity Costs  K
2

Trading costs T F
C*
C
Size of cash balance
The optimal cash balance is found where the opportunity
costs equal the trading costs

C 
* 2T F
K
 The Baumol Model
The optimal cash balance is found where the opportunity
costs equal the trading costs

Opportunity Costs = Trading Costs

C K  T F
2 C
Multiply both sides by C

C2  K  T  F C  2
2 T  F
2 K
C 
* 2TF
K
 Problems with the Baumol Model

• Cash flows may not be very predictable, much less

constant

• Treasurers may want a ‘safety stock’ of cash

 Consider Cash an ‘Inventory’

Antrade-offs:
the inventory- holdapproach to Cash
little cash = invest
remainder in M/S to earn
Balance interest
decisions:
ABC company has a daily demand for cash of $10,000. The
company invests
- if hold too excess
little cash cash in
= incur the state investment pool that
transactions
earns .01%
costs to meet per day.needs
cash In order to transfer funds from the state
pool, ABC company must pay a transaction cost of $20. How
much cash should it transfer when it runs out. (ABC company
can complete the cash - hold
transfer
lots ofelectronically
cash = forgo so
investing
it waitsinuntil
M/Sthe
cash balance is zero). and earning interest
 50000000 1002 504 339.3333333 258 210

Optimal Cash Balance via Baumol Model

Cost ($) M = $10,000 r = .01%  .0001 TC = $20

Z*  [(2M*TC)/r]
Z*=
Total Costs
Z = $63,246
Holding Costs:
(Z/2)*r

Order Costs:(M/Z)*TC

Z* Order Quantity (Z)

 The Miller - Orr Model

• The Miller-Orr Model provides a formula for

determining the optimum cash balance (Z), the
point at which to sell securities to raise cash
(lower limit L) and when to invest excess cash
by buying securities and lowering cash
holdings (upper limit H).
• Depends on:
• transaction costs of buying or selling securities
• variability of daily cash (incorporates uncertainty)
• return on short-term investments
 The Miller - Orr Model

Upper Limit Buy Securities

H

L
Lower Limit Sell Securities

Days of the Month

 The Miller-Orr Model
- Target Cash Balance (Z)

3
3 x TC x V
Z= +L
4xr
where: TC = transaction cost of buying
or selling securities
V = variance of daily cash flows
r = daily return on short-term
investments
L = minimum cash requirement
 The Miller-Orr Model
• The firm allows its cash balance to wander randomly
between upper and lower control limits.

$ When the cash balance reaches the upper control limit H cash
is invested elsewhere to get us to the target cash balance Z.
H
When the cash balance
reaches the lower
control limit, L,
investments are sold
Z to raise cash to get
us up to the target
L cash balance.

Time
 The Miller-Orr Model Math
• Given L, which is set by the firm, the Miller-Orr model
solves for Z and H

Z*3Fσ3L
2
H* 3Z* 2L
4K
where s2 is the variance of net daily cash flows.
• The average cash balance in the Miller-Orr model
is

Average 
cashbalance 4Z*
 L
3
 Implications of the Miller-Orr Model

• To use the Miller-Orr model, the manager must do

four things:
1. Set the lower control limit for the cash balance.
2. Estimate the standard deviation of daily cash flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and selling securities.
• The model clarifies the issues of cash management:
• The best return point, Z, is positively related to trading
costs, F, and negatively related to the interest rate K.
• Z and the average cash balance are positively related to
the variability of cash flows.
 Time & Money Concepts in
Working Capital Cycle

Each component of working capital (namely

inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY,
when it comes to managing working capital
 Time is Money
• You can get money to move faster around the
cycle or reduce the amount of money tied up. Then,
business will generate more cash or it will need to
borrow less money to fund working capital.
• As a consequence, you could reduce the cost of
bank interest or you'll have additional free money
available to support additional sales growth or
investment.
• Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased
credit limit, you effectively create free finance to
help fund future sales.
Corporate operational acvtivities vs cash flow
If you Then ......
Collect receivables (debtors) You release cash from the cycle
faster

Collect receivables (debtors) Your receivables soak up cash

slower

Get better credit (in terms of You increase your cash

duration or amount) from resources
suppliers
Shift inventory (stocks) faster You free up cash

Move inventory (stocks) slower You consume more cash

 Management of cash

Importance of Cash
When planning the short or long-term funding
requirements of a business, it is more important
to forecast the likely cash requirements than to
project profitability etc.

Bear in mind that more businesses fail for lack of

cash than for want of profit.
 Cash vs Profit

Sales and costs and, therefore, profits do not

necessarily coincide with their associated cash
inflows and outflows.

The net result is that cash receipts often lag cash

payments and, whilst profits may be reported, the
business may experience a short-term cash
shortfall.

For this reason it is essential to forecast cash flows

as well as project likely profits.
 Cash vs Profit
Income Statement: Month 1

Sales ($000) 75

Costs ($000) 65

Profit ($000) 10

CFs relating to Month 1: Month 1 Month 2 Month 3 Total

Amount in ($000)
Receipts from sales 20 35 20 75

Payments to suppliers etc. 40 20 5 65

Net cash flow (20) 15 15 10

(20) (5) 10 10
Cumulative net cash flow
 Calculating Cash Flows

Project cumulative positive net cash flow over

several periods and, conversely, a cumulative
negative cash flow

Cash flow planning entails forecasting and

tabulating all significant cash inflows relating to sales,
new loans, interest received etc., and then analyzing
in detail the timing of expected payments relating to
suppliers, wages, other expenses, capital
expenditure, loan repayments, dividends, tax, interest
payments etc.
 Managing cash flows

After estimating cash flows, efforts

should be made to adhere to the
estimates of receipts and
payments of cash.
Cash Management will be
successful only if cash collections
are accelerated and cash
payments (disbursements), as far
as possible, are delayed.
 Managing cash flows
Methods of ACCELERATING CASH INFLOWS
Prompt payment from customers (Debtors)
Quick conversion of payment into cash
Decentralized collections
Lock Box System (collecting centers at different
locations)

Methods of DECELERATING CASH OUTFLOWS

Paying on the last date
Payment through Cheques and Drafts
Adjusting Payroll Funds (Reducing frequency of
payments)
Centralization of Payments
Inter-bank transfers
Making use of Float (Difference between balance in Bank
Pass Book and Bank Column of Cash Book)
 Cash Pooling
Centralized cash management involves transfer
of an agency’s cash in excess of minimal
operating requirements into a centrally managed
account also known as a cash pool.
Procedure
and
Benefits
Investment of excess funds
Investment of excess funds
 The Collection & Disbursement of Public
Funds
Managing Cash Controlling Cash
Balances Collection &
• Safety Disbursement
• Liquidity • Dual responsibility
• Maximize pool of funds • Receipts maintained in
available for a location separate from
investment cash & checks
• Concentration Accounts • Certification of vouchers
• Zero-balance accounts
• Highest yield
 Collection of funds

Need for accelerating collections

How to accelerate collection of receivables
 Disbursement of funds
Importance of disbursement of funds
Review of disbursements

Payment instruments being used (checks, drafts,

wire transfers, etc.)
Bank charges and internal costs
Techniques being used
Time involved for processing of instruments
Payments Netting in Public Cash Management

Need for payments netting

Procedure involved
Only netted amount is
transferred (bilateral netting)
Netting center (multilateral
netting)