chap 5

Chapter 5 Part II Current Assets Management

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The management of cash reserve, that is cash and marketable securities, is the utmost

important to small firms and others that are operating in a tight money supply in the

financial market. Cash reserves provide margin of safety against technical insolvency

that is inability to meet current or maturing obligations. As any other financial decisions,

investment in cash reserves to maintain certain level of liquidity involves risk-return

tradeoffs.

High investments will leads to lower risk of insolvency, and lower returns. This is

because investment in cash and marketable securities offers little or no return.

Therefore, the goal is to minimize the level of cash reserve while maintaining adequate

level of liquidity. It involves:

1. Determine the appropriate degree of liquidity; that is the level of cash reserve

required. Higher liquidity represents lower risks.

2. Determine the appropriate mix of cash reserve; that is the balance between cash

and marketable securities. The decisions must account for the cost of converting

marketable securities to cash relative to its return.

The level of cash reserve depends on the certainty of firm's cash flows and the

management's attitude toward risk. Higher uncertainty of cash flows and risk-adverse

management will lead to lower risk strategy; that is holding high level of cash reserves

and vice versa.

Cash &

Marketable

Securities

Management

Part II Current Assets Management Chapter 5

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CASH MANAGEMENT

Cash in form of currency and in current accounts is the most liquid of a firm's assets. It is

used to meet immediate day-to-day payments and other purposes. The firm has four

primary reasons for holding cash:

1. Transactions: The amount of cash that a firm needs to support day-to-day

operations is a function of the firm's sales level; that is a firm must have enough

cash on hand to make its day-to-day purchases of materials and pay all its

obligations.

2. Precautionary: This need for holding cash is generally a function of the

predictability of a firm's cash inflows and outflows. The more unpredictable the

cash flows of the firm the greater the need for precautionary balances of cash.

3. Speculation: One reason a firm holds cash is to be able to take advantage of

any "bargains" that may arise.

4. Compensating Balances: These cash balances are held at banks to

compensate for services that they perform for the firm.

The recent development of liquid short-term investments, however, has diminished the

need for holding excessive precautionary and speculative balances. Many firms have

money market funds or portfolios of short-term securities that they can quickly convert to

cash should the need arise.

Cash Management Activity

The goal of cash management is to minimize the cash balance while maintaining certain

level of liquidity. Too much liquidity reduces return, whereas too little, increases risk

exposure. As outlined in Figure 5-1, cash management activity consists of several areas.


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Figure 5-1 The Cash Management Activity

Speeding up receipts

Slowing down disbursement

Management of firm cash flows

Cash budgeting

Maintaining good banking relationship

Determining the optimal cash balances

short-term financing strategies for cash shortfalls

Marketable securities investment strategies for cash excess

The cash management activity involves many aspects of the firm's operations. It relates

directly to the management of inventories, marketable securities portfolio, notes payable,

account payable, and account receivable. Therefore, the management of cash is of

utmost important to the firm as famous quotation puts it "the cash will take care of the

profits if the firm takes care of the cash."

Operating Cycle, Cash Cycle and Cash Turnover The operating cycle (OC) is the lag time in days between the purchase of raw materials

and the time cash is collected from sales of finished goods or receivables.

Consequently, cash cycle (CC) is the lag time between cash outlay to purchase raw

materials or inventories and cash is collected from receivables. Therefore, CC is the

amount of time the firm's capital is tied up in inventories sold. To illustrate this concept,

refer to Figure 5-2 that shows the movement of goods and cash in a normal business

operation.


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Figure 5-2 The Operating Cycle, Cash Cycle, and Cash Turnover OC = 110 days AAI = 70 days ACP = 40 days Purchase Raw materials Sell finished goods Accounts payable Accounts receivable 0 10 20 30 40 50 60 70 80 90 100 110 Pay account payable Collect account receivable Cash outflows Cash inflows APP = 30 days CC = 80 days

The cash cycle equals to:

OC0 = Average age of inventory (AAI) + Average collection period (ACP)

= 70 days + 40 days

= 110 days

CC0 = Average age of inventory (AAI) + Average collection period (ACP)

– Average payment period (APP)

= 70 days + 40 days – 30 days

= 80 days

Since cash cycle is a measure of the amount of time cash tied up; lower operating

cycle and cash cycle is better as the firm could recover the cash outlay in a shorter

period. Another measure of how effective cash is managed in the firm, is the cash turnover (CTO). It refers to the number of times the firm's cash is actually turned over

each year and can be calculated as follows:

CTO0 = 360 /Cash cycle

= 360 / 80

= 4.5 times


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The firm's cash cycles directly affect the amount of cash that need to be held at any

given time to support the operations. This amount represents the minimum operating cash (MOC) to avoid any cash shortages in meeting all its payments. To illustrate

consider Indah Products has an annual cash expenditures or outlays of RM300,000,

then MOC:

MOC0 = Annual Cash Outlays / Cash turnover

= 300,000 / 4.5

= RM66,666.67

Therefore, Indah needs RM66,666.67 as a minimum cash requirement to support the

firm's day-to-day operations without risk of technical insolvency. This represents a large

investment for the company, and it is crucial to minimize cash cycle and maximize cash

turnover, without scarifying the firm's liquidity and profitability. Managing the basic

elements of cash cycle that is (1) accounts payable; (2) accounts receivable; and (3)

inventories can do this. Several strategies could reduce the cash cycles and

consequently increases its turnover:

1. Increasing Average Payment Period. It involves delaying payments on accounts

payable as late as possible (ALAP) without damaging the firm's credit rating. In

addition, favorable cash discount should not be ignored as the opportunity cost is

high if not taken.

2. Reducing Average Inventory of Age. This is to increase inventory turnover as

quickly as possible by (1) efficient management of inventories, (2) better production

planning, scheduling, and control, (3) effective sales forecasting, and (4) synchronize

the production and demand.

3. Reducing Average Collection Period. It involves speeding up collection of account

receivable as soon as possible (ASAP) without losing potential sales. The use of

proper techniques such as changes in credit policies and collection policies that will

improve collection period will benefits the company.


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The implementations of the above strategies will reduce cash cycles, and thus will result

in freeing some of the capital tied up in inventories and account receivable. The freed

capital that is available for other investment opportunities that could provide additional

return to the firm and/or reduces the cost of financing.

To illustrate, let assume that Indah in the above example able to:

1. Negotiate a better credit term with its suppliers from net 30 to net 35

2. Improve production process and selling effectiveness that reduces average age

of inventory by 10 days to 60 days.

3. Decrease average collection period by 7 days to 33 days by changing its credit

terms.

Other things held constant, the above changes are expected to improve the firm's

performance as it will result in lower of cash cycle, higher cash turnover and lower

minimum operating cash.

CC1 =

= 58 days.

CTO1 =

= 6.21 times

MOC1 =

= RM48,309.17

The above changes will have several impacts:

1. Shorter cash cycle, and thus higher cash turnover.

Change in CC = CC1 - CC0 =

= (22 days)


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Change in CTO = CTO1 - CTO0 =

= 1.71 times

2. Lower minimum operating cash requirements, and hence lower investment in

cash to support the firm's operations.

Change in investment MOC = MOC1 - MOC0

=

= (RM18,357.50)

3. Lower cost of financing and higher profits. If the cost of funds is at 10 percent,

the firm can realize a yearly saving of RM1,835.75.

Change in cost of financing = Change in MOC x Cost of funds

=

= (RM1,835.75)

The effects of lower cash cycle are quite significant for large firms with cash reserves

and cash outlays that run in millions of Ringgits. Therefore, proper cash management

will have a direct impact on the firm's liquidity and profits. These represent a tradeoff that

needs to be balanced to ensure that all obligations are met without sacrificing the needs

for higher profits.

MARKETABLE SECURITIES MANAGEMENT

Although marketable securities typically provide much lower yields than firm's operating

assets, many firms hold large holdings of these securities. There are several reasons for

a firm holding these types of liquid assets:

1. Marketable Securities are a Substitute for Cash. In many cases, these securities

are held primarily for precautionary purposes. Most firms prefer to rely on bank credit


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to make temporary transactions or to meet speculative needs, but they still hold

some liquid assets to guard against a possible shortage of bank credit or to handle

possible emergencies.

2. Marketable Securities as a Temporary Investment. Often a firm uses these

securities as a temporary holding place for surplus cash flows. For example to hold

the proceeds from a long-term security issue until the funds can be used to purchase

operating assets.

Regardless of the motives, it will provide return from idle funds. In order to spread the

risk, marketable securities portfolio usually consists of different types of securities

with different maturity, liquidity, and returns.

Factors Influencing the Choice of Securities

A firm must consider several factors in choosing the marketable securities that it will

hold:

1. Default Risk. The risk that an issuer will be unable to make interest payments, or to

repay the principal amount on schedule, is known as default risk.

2. Interest Rate Risk. As we saw in Chapter 4, bond prices very with changes in the

interest rates; and in general, longer-term bonds tend to have more variability (or

interest rate risk) than shorter-term bonds.

3. Purchasing Power Risk. This is the risk that inflation will reduce the purchasing

power of a given sum of money. In general, real estate and common stock (whose

returns normally rise during inflation) are often thought of as better "hedges against

inflation" than the bonds and other fixed income securities.

4. Liquidity Risk. An asset that can be sold on short nice for close to its quoted price is

defined as being liquid. This particular quality is very important if a firm's need for

funds tends to be very volatile.


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5. Return on Securities. In general, the higher the risk of a given security the higher

the return on that security. Thus corporate treasurers, like other investors, must

make a tradeoff between risk, and return when choosing investments for their

portfolios.

Due to the required use of a firm's short-term portfolio, it should be of the highest quality.

Accordingly, the investments in this portfolio should be confined to safe, highly liquid,

short-term securities issued by either the U.S. government or the very strongest

corporations. Given the purpose of the securities portfolio, treasurers are unwilling to

sacrifice safety for higher rates of return.

Alternative investment In the money market, there are wide ranges of marketable securities available, which

carry various characteristics. Short- term securities can be grouped either as

government issues such as treasury bills, or private issues such as commercial paper.

Treasury bills (T-bills). Are a Government Issue, and therefore, the obligation of the

Treasury Department. Most of the T-bills matures in 91-182 days, with longer maturities

such as 9 months or one year are sold from time to time and in smaller amount. It is

auctioned weekly at a discount with the smallest denomination of RM1,000 and

considered as risk-free. Evaluations: High liquidity with strong secondary market, lowest

risk, and low return.

Treasury notes (T-notes). It is similar to T-bills, it is the obligations of the Treasury

department. However, its initial maturity is between 1 – 7 years. It is held in the

marketable securities portfolio because of security and liquidity. Evaluations: High

liquidity with strong secondary market, lowest risk, and returns is slightly higher than T-

bill.

Negotiable certificate of deposits (NCDs). Is a negotiable instrument as an evidence

of deposit in a commercial bank. The amount (smallest RM100,000) and the maturity

(commonly 30 days) are based on the investor's (depositor's) needs. Evaluations: High


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liquidity with strong secondary market, moderate risk that depends on the bank

involved, high return.

Commercial paper (CP). Commercial paper is a short-term unsecured promissory note

issued by a large firm with high credit standing. It maturities may range from 3 – 270

days, as longer maturities require a formal registration. Evaluations: Low liquidity with

weak secondary market, moderate risk that depends on the issuer, return is slightly

lower than CDs.

Banker's acceptance (BAs). It is similar to cashier's check payable in future, with

typical maturity of 30 days or 180 days. BAs result from a short-term credit arrangement

between purchaser and its bank to finance transactions. The purchaser with its bank

approval issues a draft, on which payment is contingent on some events, to the seller

for the amount purchased. The seller who holds BAs, then may sell it at a discount in

the secondary market to obtain immediate funds. Evaluations: High liquidity with strong

secondary market, moderate risks since it involves three parties, high return similar to

CP.

Other types of securities are available that can be part of the marketable securities

portfolio. The five securities presented above are the most commonly available and

demanded in the money market. As for the Malaysian context, the major money market

instruments are: (1) Bankers Acceptance, BA; (2) Negotiable Money market Instrument,

NCD; (3) Malaysian Government Securities, MGS is a long-term domestic borrowing;

(4) Malaysian Government Treasury Bills, MGTB is a short-term domestic borrowing;

and (5) Cagamas, unsecured bond issued by Perbadanan Cagaran Malaysia Berhad.

The cash and marketable securities management are highly dependent on each other,

and therefore it must be managed concurrently. These two liquid assets represent the

firm's storehouse of liquidity that aids its effort to maintain long-term viability and ability

to increase stockholders’ wealth.


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FINAL EXAM QUESTIONS September 2002: Section B. Question 2(a) Sri Temenggong Company’s have an average age of inventories of 80 days, an average

collection period of 65 days and an average period of 30 days. The company spends RM

1 million per year. Assuming a 360-day cycle, calculate the firm’s:

i. Cash cycle

ii. Cash turnover

iii. Minimum operating cash balance the firm must maintain to meet its obligations.

(6 marks)

September 2002: Section B. Question 5(b) List two (2) types of marketable securities and briefly explain each of them.

(2 marks)


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April 2003: Section B. Question 3(c) a. Cik NH is planning to determine the firm’s minimum operating cash to reduce the

firm’s cost of investment. The firm is selling on terms net 45 and pays all credit

purchases on net 30. The firm takes 60 days to produce and sell the products. If the

firm’s yearly outlay is RM 500,000, calculate the:

i. Cash cycle

ii. Cash turnover (1 year = 360 days)

iii. Minimum operating cash

(5 marks) March 2002: Section B. Question 2(a) Jaya Berhad is planning to purchase raw materials on 5th April, 2002 and the payment

will be on credit term 5/10 net 30. The goods will be sold on 4th July, 2002. Sales of the

goods are RM60,000. Total accounts receivable are RM20,000 and total annual outlays

are RM30,000. You are required to find:

i) The cash cycle

ii) The cash turnover

iii) The minimum operating cash

(6+2+2=10 marks)


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September 2001: Section B. Question 5(b) Clearly explain the three reasons of holding cash.

(5 marks)

April 2001: Section B. Question 2(b) PCK Jurong Company, a producer of safety boot sells its merchandise on credit. The

company’s operation department reveals that on average, it takes 40 days to

manufacture, warehouse and ultimately sell finished goods (its average age of inventory

(AAI)).

The average collection period (ACP) indicates that it is taking the firm on average 70

days to collect its account receivable and average payment period (APP) for raw

materials and labor is 30 days.

Find:

a. PCK Jurong Company’s cash cycle.

b. PCK Jurong Company’s cash turnover. Assume 360 days a year.

c. PCK Jurong Company’s minimum operating cash, if the total annual outlay is

RM900,000.

(15 marks)

October 2000: Section B Question 1 (b) Write short notes on the following: i) Malaysian government securities ii) Negotiable certificate of deposits iii) Commercial paper iv) Cagamas bond (8 marks)


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April 2000: Question 7(b) Briefly, explain three factors that influence investment in marketable securities. (3 marks) April 99: Question 7(i) i) Senang Company has inventory of 90 days, average collection period is 40 days,

and payment period is 30 days.

a) What is the length of firm’s cash cycle? (3 marks) b) If the company’s annual sales are RM 4 million and 70% of the firm’s sales are

on credit, calculate the firm’s account receivable. (3 marks)

c) Determine its cash turnover. (3 marks)

April 97: Question 7 The LIT-TAK Corporation has an inventory age of 75 days, a receivable collection period of 38 days and payment period of 30 days. (a) What is the length of the firm’s cash cycle? (b) If the company’s annual sales are RM 3.375 million and 60 % of the firm’s sales are

on credit, what is the firm’s account receivable? (c) What is its cash turnover?

( 6 marks) November 1996: Question 4

(a) MH Company is planning to purchase raw materials on August 4, 1997 and the

payment will be on credit term 3/6 net 30. The goods will be sold on November 2,

1997. Sales of the goods are RM 60,000 with 60 % of it on credit. Total accounts

receivables are RM 10,000. Total annual outlays are RM 22,500. Find:

(i) the cash cycle (ii) Cash turnover and (iii) the minimum operating cash.

(Hint: Find the ACP first) ( 8 marks)

chap 5

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