11.2 Cash and Marketable Securities Management
3 min read•july 18, 2024
Cash and are crucial for businesses to maintain financial stability and seize opportunities. Companies hold cash for transactions, precautions, and speculation, while also utilizing as near-cash assets to earn higher returns.
The measures the time between cash outflows and inflows, impacting . help forecast and manage cash flows, while short-term investment options like T-bills and allow businesses to balance , , and for excess funds.
Cash and Liquidity Management
Motives for cash holdings
Top images from around the web for Motives for cash holdings
Buying and Selling at Securities Exchanges | OpenStax Intro to Business View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
The Role of Finance and the Financial Manager | OpenStax Intro to Business View original
Is this image relevant?
Buying and Selling at Securities Exchanges | OpenStax Intro to Business View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
1 of 3
Top images from around the web for Motives for cash holdings
Buying and Selling at Securities Exchanges | OpenStax Intro to Business View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
The Role of Finance and the Financial Manager | OpenStax Intro to Business View original
Is this image relevant?
Buying and Selling at Securities Exchanges | OpenStax Intro to Business View original
Is this image relevant?
U.S. Financial Institutions | OpenStax Intro to Business View original
Is this image relevant?
1 of 3
- Transaction motive
- Holds cash to cover routine business expenses (payroll, rent, utilities)
- Ensures smooth day-to-day operations without disruptions
- Precautionary motive
- Maintains as a safety net for unforeseen expenses (equipment breakdowns, lawsuits)
- Provides financial stability during uncertain times (economic downturns, natural disasters)
- Speculative motive
- Keeps cash available to capitalize on profitable opportunities (discounted inventory purchases, acquisitions)
- Allows flexibility to act quickly when favorable investments arise
- Marketable securities serve as near-cash assets
- Highly liquid convertible to cash within a year (, money market funds)
- Earn higher returns than cash while maintaining liquidity for future needs
Cash conversion cycle impact
- Cash conversion cycle measures time between cash outflows for inventory and cash inflows from sales
- Formula:
- : , average time to sell inventory
- : , average collection period for accounts receivable
- : , average payment period for accounts payable
- Shorter indicates more efficient
- Faster inventory turnover reduces carrying costs and obsolescence risk
- Quicker collection of accounts receivable improves cash flow and reduces bad debt
- Longer payment terms with suppliers allows more time to generate cash from sales
- Longer may strain liquidity and increase financing costs
- Slow-moving inventory ties up cash and may require markdowns to sell
- Delayed customer payments create cash flow gaps and may lead to write-offs
- Shorter payment terms with suppliers require cash outflows before generating sales
Cash budgeting techniques
- projects expected cash inflows and outflows over a defined period
- Identifies potential cash surpluses for investment or cash deficits requiring financing
- Allows proactive management of liquidity to avoid shortfalls or idle cash
- Steps to create a cash budget:
- Estimate expected cash receipts from various sources (sales, investments, loans)
- Estimate expected cash disbursements for various purposes (expenses, loan payments, dividends)
- Calculate net cash flow by subtracting cash disbursements from cash receipts
- Determine ending cash balance by adding net cash flow to beginning cash balance
- tests impact of changes in assumptions on cash budget outcomes
- Identifies potential risks (lower sales, higher expenses) and opportunities (faster collections, cheaper financing)
- Prepares contingency plans for various scenarios to ensure adequate liquidity
Short-term investment options
- Criteria for evaluating :
- Safety minimizes risk of default or loss of principal (government-backed securities, insured deposits)
- Liquidity enables quick conversion to cash without significant loss of value (money market funds)
- Yield maximizes return on investment while balancing safety and liquidity (commercial paper)
- Treasury bills are short-term government securities maturing within a year
- Backed by full faith and credit of the U.S. government, considered risk-free assets
- Sold at a discount from face value, difference represents interest earned at maturity
- Commercial paper is unsecured short-term debt issued by corporations to fund operations
- Higher yields than due to slightly higher default risk of corporations vs. government
- Typically issued by large, creditworthy companies to minimize risk for investors
- Certificates of deposit are time deposits with fixed maturity dates and interest rates
- FDIC insurance up to $250,000 per depositor per bank eliminates risk of loss
- Early withdrawal penalties incentivize holding to maturity to earn stated return
- Money market funds invest in a diversified portfolio of short-term, high-quality debt securities
- Provides liquidity by allowing investors to withdraw funds on demand
- Offers higher yields than bank accounts while maintaining stable $1 per share net asset value
Key Terms to Review (30)
Asset Allocation: Asset allocation is the process of distributing investments across various asset classes, such as stocks, bonds, and cash, to balance risk and return according to an investor's goals and risk tolerance. This strategy helps in managing overall portfolio risk and can significantly influence investment performance over time.
Basel III: Basel III is an international regulatory framework established to strengthen the regulation, supervision, and risk management within the banking sector. It aims to improve the banking sector's ability to absorb shocks arising from financial and economic stress, enhancing transparency and reducing systemic risk. The framework sets higher capital requirements and introduces new regulatory requirements on bank liquidity and leverage, which are crucial for ensuring stability in the financial system.
Baumol Model: The Baumol Model is a cash management theory that helps firms determine the optimal amount of cash to hold while minimizing the costs associated with cash management and transaction fees. It combines elements of inventory management with cash flow analysis to guide firms in balancing the trade-off between having enough cash for operational needs and minimizing excess cash that doesn't earn returns.
Cash budget: A cash budget is a financial plan that estimates cash inflows and outflows over a specific period, helping organizations manage their cash resources effectively. This budget is crucial for ensuring that a company has enough liquidity to meet its obligations while also planning for any surplus cash that can be invested or used for expansion. It provides insights into cash flow timing, enabling better decision-making related to cash reserves and financing needs.
Cash budgeting techniques: Cash budgeting techniques are methods used to forecast and manage cash flows, ensuring that an organization has enough liquidity to meet its obligations. These techniques help in planning for expected cash inflows and outflows over specific periods, which is crucial for effective financial management. By employing these techniques, businesses can avoid cash shortages and make informed decisions regarding investments and expenses.
Cash Conversion Cycle: The cash conversion cycle (CCC) is a financial metric that measures the time it takes for a company to convert its investments in inventory and accounts receivable into cash flows from sales. It connects various aspects of financial management, as it highlights how efficiently a company is managing its working capital, specifically in relation to how quickly it can collect cash from customers after selling goods or services.
Cash Forecasting: Cash forecasting is the process of estimating future cash inflows and outflows over a specific period to ensure a business can meet its financial obligations. This process helps organizations manage liquidity, optimize cash reserves, and plan for potential shortfalls or surpluses, playing a critical role in effective cash and marketable securities management.
Cash Management: Cash management refers to the process of collecting, managing, and optimizing a company's cash flows to ensure sufficient liquidity for its operational needs while maximizing the efficiency of cash usage. This involves monitoring cash inflows and outflows, managing short-term investments, and ensuring that the firm can meet its financial obligations on time. Effective cash management is crucial for maintaining business stability and can significantly impact a company’s profitability and growth.
Cash reserves: Cash reserves are the liquid assets that a company holds to meet short-term obligations and emergencies. They serve as a financial safety net, allowing businesses to manage operational expenses, navigate unexpected costs, and seize investment opportunities without relying on external funding sources. Maintaining adequate cash reserves is crucial for ensuring liquidity and financial stability.
Commercial Paper: Commercial paper is an unsecured, short-term debt instrument issued by corporations to raise funds, typically for working capital needs. It usually matures in 1 to 270 days and is sold at a discount from its face value, making it a cost-effective financing option. Companies use commercial paper as an alternative to bank loans or lines of credit, and it plays a crucial role in the money market as a source of liquidity for businesses.
Days Inventory Outstanding: Days Inventory Outstanding (DIO) is a financial metric that measures the average number of days a company takes to sell its entire inventory during a specific period. This metric is important because it helps businesses evaluate their efficiency in managing inventory, which can directly impact cash flow and overall financial health. A lower DIO indicates that a company is selling its inventory quickly, while a higher DIO may suggest inefficiencies or overstocking, making it essential for effective cash and marketable securities management.
Days Payable Outstanding: Days Payable Outstanding (DPO) is a financial metric that measures the average number of days a company takes to pay its suppliers after receiving goods or services. This metric is crucial for assessing a company's cash flow management and overall financial health, as it directly impacts working capital and liquidity. A higher DPO indicates that a company is taking longer to pay its bills, which can free up cash for other operational needs but may also strain supplier relationships.
Days Sales Outstanding: Days Sales Outstanding (DSO) is a financial metric that measures the average number of days it takes a company to collect payment after a sale has been made. A lower DSO indicates that a company is efficient in collecting receivables, which positively impacts cash flow. This metric is critical for understanding how well a company manages its accounts receivable and contributes to effective cash and marketable securities management.
Just-in-time inventory: Just-in-time inventory is a management strategy that aligns raw-material orders from suppliers directly with production schedules. This approach reduces inventory costs and minimizes waste by receiving goods only as they are needed in the production process, effectively optimizing the supply chain. The strategy relies on strong relationships with suppliers and precise demand forecasting to ensure that materials are available just in time for production, which is essential for improving efficiency and reducing excess stock.
Liquidity: Liquidity refers to the ease with which an asset can be quickly converted into cash without significantly affecting its value. It plays a vital role in financial management by ensuring that organizations can meet their short-term obligations, invest in opportunities, and navigate market fluctuations smoothly.
Liquidity Efficiency: Liquidity efficiency refers to the ability of an organization to quickly convert its assets into cash without significantly affecting the asset's value. This concept is crucial in managing cash and marketable securities, as it ensures that a company can meet its short-term obligations while optimizing its investment in liquid assets. Efficient liquidity management balances the need for readily available cash with the goal of maximizing returns on excess funds.
Liquidity Management: Liquidity management is the process of ensuring that an organization has enough cash and liquid assets to meet its short-term obligations. This involves balancing cash inflows and outflows, while also managing marketable securities to ensure that assets can be converted into cash quickly without significant loss of value. Effective liquidity management is crucial for maintaining operational stability and avoiding financial distress.
Liquidity management: Liquidity management is the process of ensuring that a company has sufficient cash flow to meet its short-term obligations while also optimizing the use of its liquid assets. It plays a crucial role in financial decision-making by balancing the need for immediate cash availability against the opportunity cost of holding non-earning assets. Effective liquidity management impacts various financial activities such as investment strategies, dividend policies, and operational funding.
Marketable securities: Marketable securities are financial instruments that can be quickly converted into cash at a reasonable price, typically within a year. These include stocks, bonds, and other investments that are actively traded in financial markets, making them highly liquid assets. They play a crucial role in cash and marketable securities management, providing companies with the flexibility to respond to immediate cash needs while also earning returns on excess cash.
Maturity date: The maturity date is the specific date on which a financial instrument, such as a bond or a note, is due to be paid back in full, including any interest owed. It serves as a critical element in determining the lifespan of the investment and affects its yield and pricing. Understanding the maturity date helps investors assess the risk and liquidity of their investments, as longer maturities usually entail greater risks and price volatility compared to shorter maturities.
Miller-Orr Model: The Miller-Orr Model is a financial management tool used to determine optimal cash levels within an organization by setting a target cash balance and allowing for variations in cash flows. It helps firms manage their liquidity efficiently by providing guidelines on when to invest excess cash and when to borrow funds. The model accounts for transaction costs and cash flow variability, making it a practical solution for managing cash reserves.
Portfolio diversification: Portfolio diversification is the investment strategy of spreading investments across various financial assets to reduce risk. By holding a mix of asset types—such as stocks, bonds, and real estate—investors can minimize the impact of any single asset's poor performance on the overall portfolio. This strategy is crucial for managing both systematic and unsystematic risk, and it can influence cash management practices as well as derivative trading strategies.
Risk-return tradeoff: The risk-return tradeoff is a financial principle that suggests the potential return on an investment increases with an increase in risk. Investors must balance the desire for the highest return against the potential for loss, leading them to seek investments that align with their risk tolerance and return expectations.
Safety: Safety in finance refers to the assurance that an investment is secure and has a low risk of loss, ensuring the preservation of capital. This concept is crucial when managing cash and marketable securities, as it prioritizes the protection of funds while still allowing for liquidity and accessibility. The emphasis on safety often leads to the selection of conservative investment options that provide reliable returns without significant risk exposure.
SEC Regulations: SEC regulations refer to the rules and guidelines established by the U.S. Securities and Exchange Commission (SEC) to govern the securities industry, ensuring transparency, fairness, and protection for investors. These regulations play a crucial role in shaping corporate behaviors, influencing dividend policies, managing cash and marketable securities, and guiding options valuation strategies, ultimately maintaining market integrity and investor confidence.
Sensitivity analysis: Sensitivity analysis is a financial modeling technique used to determine how different values of an independent variable can impact a particular dependent variable under a given set of assumptions. This process helps identify which variables have the most influence on the outcomes of financial decisions, particularly in evaluating investment projects, assessing risks, and optimizing capital allocations.
Short-term investments: Short-term investments are financial instruments that are expected to be converted into cash within one year or less. These investments are typically low-risk and liquid, making them suitable for individuals or businesses looking to maintain easy access to their funds while still earning some level of return. They often include marketable securities, treasury bills, and certificates of deposit, allowing investors to manage their cash flow effectively.
Short-term investments: Short-term investments are financial instruments that are expected to be converted into cash or consumed within one year or less. These investments typically offer lower returns compared to long-term investments but provide liquidity and flexibility, making them essential for managing cash flows and ensuring that funds are available for immediate needs.
Treasury Bills: Treasury bills, commonly known as T-bills, are short-term government securities issued by the U.S. Department of the Treasury to finance national debt. They are sold at a discount and have maturities ranging from a few days to one year, providing investors with a safe and liquid investment option. The connection between T-bills and the financial markets is significant, as they serve as a benchmark for other interest rates, impact liquidity in the market, and reflect the overall economic conditions.
Yield: Yield is a financial term that represents the income generated from an investment over a specified period, typically expressed as a percentage of the investment's cost or current market value. It serves as a key metric for assessing the performance of investments, particularly cash and marketable securities, where investors seek to maximize returns while managing risk. Understanding yield is crucial for making informed decisions about where to allocate funds in order to achieve desired financial objectives.