11.3 Cash and Liquidity Management

Cash and liquidity management is crucial for businesses to balance operational needs with investment opportunities. This section explores the motives for holding cash, the trade-off between liquidity and profitability, and various techniques for optimizing cash flow.

Companies use models like Baumol and Miller-Orr to determine optimal cash balances. They also consider short-term investment options, ranging from low-risk Treasury bills to higher-yield alternatives like commercial paper, to maximize returns on excess cash.

Cash Holding Motives vs Profitability

Motives for Holding Cash

• Transaction motive maintains sufficient funds for day-to-day operational expenses and planned expenditures
• Precautionary motive keeps a reserve to cover unexpected expenses or opportunities
• Speculative motive preserves funds to capitalize on unforeseen investment opportunities
• Compensating balance motive maintains minimum account balances offsetting bank service charges or supporting loan arrangements
  • Example: Maintaining a $10,000 minimum balance to avoid monthly fees

Liquidity and Profitability Trade-off

• Liquidity enables easy and rapid conversion of assets into cash without significant value loss
  • Example: Cash in a checking account (highly liquid) vs. real estate investment (less liquid)
• Profitability generally inversely relates to liquidity
  • Highly liquid assets typically offer lower returns (savings account)
  • Less liquid investments often provide higher returns (stocks, bonds)
• Optimal cash balance strikes equilibrium between operational cash needs and investing excess cash for returns
  • Example: A company keeping $100,000 in cash for operations while investing $500,000 in short-term securities

Cash Flow Management Techniques

Float Management

• Float represents time lag between payment initiation and fund availability
  • Comprises mail float, processing float, and availability float
• Lockbox systems utilize strategically located post office boxes accelerating accounts receivable collection
  • Example: A national retailer using regional lockboxes to speed up customer payments
• Electronic funds transfer (EFT) systems significantly reduce float time for collections and disbursements
  • Automated Clearing House (ACH) for recurring payments
  • Wire transfers for large, time-sensitive transactions

Cash Flow Optimization Strategies

• Controlled disbursement strategically times payments maximizing float while maintaining good supplier relationships
  • Example: Scheduling vendor payments on Fridays to gain weekend float
• Zero-balance accounts (ZBAs) automatically transfer funds from master account to subsidiary accounts minimizing idle cash balances
  • Example: A corporation using ZBAs for its various regional offices
• Concentration banking employs regional bank accounts to collect funds, then transfers to a central account for efficient cash management
  • Example: A national chain consolidating daily sales from multiple locations into a main account
• Cash forecasting techniques essential for effective cash flow management
  • Receipts and disbursements method projects cash inflows and outflows
  • Adjusted net income method starts with projected net income and adjusts for non-cash items

Optimal Cash Balance Models

Baumol Model (Economic Order Quantity Model)

• Assumes steady, predictable rate of cash outflows and fixed cost for converting securities to cash
• Calculates optimal cash balance balancing opportunity cost of holding cash against transaction costs of converting securities
• Formula: $C* = \sqrt{\frac{2bT}{i}}$
  • C* optimal cash balance
  • b fixed cost per transaction
  • T total cash needed for period
  • i opportunity cost of holding cash
• Example: Company with $1,000,000 annual cash needs, $50 transaction cost, and 5% opportunity cost
  • Optimal cash balance: C* = \sqrt{\frac{2 * 50 * 1,000,000}{0.05}} = $44,721

Miller-Orr Model

• More realistic accounting for cash flow uncertainty allowing upper and lower control limits
• Cash balances fluctuate between lower limit and upper limit with a return point in between
• Formula for return point: $Z = 3\sqrt{\frac{3\sigma^2b}{4i}}$
  • Z return point
  • σ² variance of daily cash flows
  • b fixed transaction cost
  • i daily interest rate
• Example: Company with daily cash flow variance of $1,000,000,$100 transaction cost, and 0.02% daily interest rate
  • Return point: Z = 3\sqrt{\frac{3 * 1,000,000 * 100}{4 * 0.0002}} = $32,767

Short-Term Investment Risks and Returns

Low-Risk Investment Options

• Treasury bills offer lowest risk and returns with 4, 13, 26, or 52-week maturities
  • Example: 13-week T-bill yielding 1.5% annually
• Certificates of Deposit (CDs) provide fixed interest rates with early withdrawal penalties
  • Example: 6-month CD offering 2% APY
• Money market mutual funds invest in diversified short-term, high-quality debt instruments
  • Example: Vanguard Prime Money Market Fund with a 7-day yield of 1.8%

Higher-Yield Investment Alternatives

• Commercial paper represents short-term, unsecured corporate promissory notes with maturities up to 270 days
  • Example: 30-day commercial paper from a blue-chip company yielding 2.2%
• Repurchase agreements (repos) involve securities sale with agreement to repurchase at higher price
  • Example: Overnight repo with 1.5% annualized return
• Eurodollar deposits offer U.S. dollar-denominated deposits in foreign banks with potentially higher yields but increased currency risk
  • Example: 3-month Eurodollar deposit yielding 2.5%

Investment Evaluation Factors

• Liquidity assesses ease of converting investment to cash
• Yield measures potential return on investment
• Credit risk evaluates possibility of default or non-payment
• Interest rate risk considers impact of rate changes on investment value
• Tax implications affect after-tax returns on investments
  • Example: Municipal bonds offering tax-free interest income