Cash Management: Short-term Finance and Liquidity Management

Unit Learning Outcomes

• On successful completion of this unit, you should be able to:
• explain the role of treasury operations in an international or a local bank
• describe how risk management processes work
• demonstrate the application of hedging techniques used in banks' treasury operations
• apply critical thinking, problem solving and presentation skills to individual and/or group activities dealing with treasury management and demonstrate in an individual summative assessment task the acquisition of a comprehensive understanding of the topics covered by BFF3651.

Resources

• Lecture note
• Ross, Westerfield, and Jordan
• Lecture note is the main reading material for week 2

Short-term Finance and Planning

What is short-term finance?

• Also known as working capital management
• Cash inflows and outflows within a year

Why is tracing cash challenging? The cash inflows and outflows are

• unsynchronized because, for example, the payment of cash for raw materials does not happen at the same time as the receipt of cash from selling the product.
• uncertain because future sales and costs cannot be precisely predicted.

Since tracing cash is challenging, you need a short-term finance plan.

Learning Objectives Overview

• The operating and cash cycles and why they are important (L01)
• The different types of short-term financial policy (L02)
• The sources of cash on the balance sheet (L03)
• Cash management vs liquidity management (L04)
• Cash disbursement techniques (L05)
• Some of the ways to invest idle cash (L06)
• How firms manage short-term credit (L07)
• How firms manage inventories (L08)

Operating and Cash Cycles Concepts

• Related concepts:
• Operating cycle: The period between the acquisition of inventory and the collection of cash from receivables.
• Cash cycle: The time between cash disbursement and cash collection
• Inventory period: The time it takes to acquire and sell inventory
• Accounts receivable period: The time between sale of inventory and collection of the receivable.
• Accounts payable period: The time between receipt of inventory and payment for it.

Operating and Cash Cycles Quick Review

• The Operating Cycle and the Cash Cycle: Quick review
• One day, call it Day o, we purchase $1,000 worth of inventory on credit.
• We pay the bill 30 days later; and after 30 more days, someone buys the $1,000 in inventory for $1,400.
• Our buyer does not actually pay for another 45 days. We can summarize these events chronologically as follows:

Day Activity Cash Effect 0 Acquire inventory None 30 Pay for inventory -$1,000 60 Sell inventory on credit None 105 Collect on sale +$1,400

Operating and Cash Cycles Timeline

Inventory purchased Inventory sold Inventory period Accounts receivable period Time Accounts payable period Cash cycle Cash received Cash paid for inventory Operating cycle The operating cycle is the period from inventory purchase until the receipt of cash. (The operating cycle may not include the time from placement of the order until arrival of the stock.) The cash cycle is the period from when cash is paid out to when cash is received. Cashflow timeline: In previous example, Operating cycle = Inventory period + Accounts receivable period 105 days = 60 days + 45 days Cash cycle = Operating cycle - Accounts payable period 75 days = 105 days - 30 days

Monitoring the Cash Cycle

• Why do treasures monitor the cash cycle?
• The longer the cash cycle, the more financing is required.
• Changes (mainly increases) in the firm's cash cycle are often monitored as an early-warning measure.
• A lengthening cycle can indicate that the firm is having trouble moving inventory or collecting on its receivables. Such problems can be masked, at least partially, by an increased payables period; so both cycles should be monitored.
• Cash cycle and profitability:
  • Measure of profitability: Return on Assets (ROA) = Net income/total assets
  • All other things being the same, the shorter the cash cycle is, the lower the firm's investment in inventories and receivables.
  • As a result, the firm's total assets are lower, and ROA is higher.

Amazon vs. Barnes & Noble Cash Cycle

The case of Amazon V. Barnes & Noble

• By mid-2008, the market value of Amazon.com was higher than (in fact, more than 22 times as much as) that of Barnes & Noble, king of the brick-and-mortar bookstores, even though Amazon's sales were only 2.7 times greater.
• Amazon had better short-term finance planning
  • Amazon turned over its inventory about 11 times per year, 4 times faster than Barnes & Noble; so its inventory period was dramatically shorter.
  • Even more striking, Amazon charges a customer's credit card when it ships a book, and it usually gets paid by the credit card firm within a day.

Short-term Financial Policy Determination

• A treasurer will determine the size of the firm's investment in current assets:
  • A flexible, or accommodative, short-term financial policy: High ratio of current assets to sales
  • A restrictive short-term financial policy: Low ratio of current assets to sales
• A treasurer will determine how to finance current assets:
  • A flexible, or accommodative, short-term financial policy: a low proportion of short-term debt relative to long-term financing
  • A restrictive short-term financial policy: a high proportion of short-term debt relative to long-term financing

Flexible Policy and Shortage Costs

• Flexible policy provides higher working capital/liquidity and reduces shortage costs
• Two types of shortage costs:
  • Trading costs: If a firm runs out of cash, it will be forced to sell marketable securities. Of course, if a firm runs out of cash and cannot readily sell marketable securities, it may have to borrow or default on an obligation. This situation is called a cash-out.
  • Costs related to lack of safety reserves: A firm may lose customers if it runs out of inventory (a stockout ) or if it cannot extend credit to customers.

What are the plausible costs of flexible policy? Carrying costs>>opportunity costs of holding current assets

• Treasurer will identify the optimal level of current assets that will reduce costs.

Optimal Investment in Current Assets

Short-term financial policy: the optimal investment in current assets

Total cost of holding current assets Minimum point Carrying costs Dollars Shortage costs CA* Amount of current assets (CA) CA* represents the optimal amount of current assets. Holding this amount minimizes total costs. Carrying costs increase with the level of investment in current assets. They include the costs of maintaining economic value and opportunity costs. Shortage costs decrease with increases in the level of investment in current assets. They include trading costs and the costs related to being short of the current asset (for example, being short of cash). The firm's policy can be characterized as flexible or restrictive.

Flexible Policy Characteristics

A. Flexible policy

Minimum point Total cost Dollars Carrying costs Shortage costs CA* Amount of current assets (CA) A flexible policy is most appropriate when carrying costs are low relative to shortage costs.

Restrictive Policy Characteristics

B. Restrictive policy

Minimum point Total cost Carrying costs Dollars Shortage costs CA* Amount of current assets (CA) A restrictive policy is most appropriate when carrying costs are high relative to shortage costs.

Cash Budgeting

• The cash budget: records estimates of cash receipts (cash in) and disbursements (cash out), resulting in an estimate of the cash surplus or deficit.
• Example: Predicted sales of Fun Toys are:

Q1 Q2 Q3 Q4 Sales (in millions) $200 $300 $250 $400

• Assume sales are distributed equally over a particular quarter. Thus, in Q1, per day sale = 200/90 = 2.22 millions
• Fun Toys has a 45-day receivable collection period.
• Sales made during the first 45 days of a quarter will be collected in that quarter, whereas sales made in the second 45 days will be collected in the next quarter. Each quarter has 90 days
• Fun Toys started the year with accounts receivable equal to $120 m.
• Cash collections = Beginning accounts receivable +1/2 Sales = 120 + 1/2 of 200 = 220 m