HANDOUT

CASH MANAGEMENT
OVERVIEW OF CASH MANAGEMENT

The Cash Balance

Cash is a commodity, it is not an investment. It has to be invested to produce wealth. Theoretically, cash represents an idle
resource, unless the cash balance is maintained to meet loan conditions, deposit arrangements, petty cash transactions, or
business exigencies. Managing cash is a treasurer’s domain. Cash balance should be at its optimum and cash flows (inflows and
outflows) should be synchronized. In reality, the optimum cash balance is difficult to maintain. In case of cash deficiency, the
treasurer activates various financing lines such as the standby bank credit, sale of noncurrent assets, issuance of additional
shares of stock, or accelerating collections from customers. In case of cash excesses, it should be known whether the excess
is permanent or temporary. If the excess cash is permanent it should be channeled to permanent or long-term investments.
Temporary excess cash should be placed in temporary investments.

The Optimum Cash Balance

Theoretically, a desired cash balance is the optimum cash balance where the total relevant costs of cash would be at the
minimum. The relevant costs of cash are its holding costs and opportunity costs. A desired cash balance may be established
by using the subjective model or the quantitative model. Cash inflows and outflows should be synchronized. Cash inflows should
be accelerated and cash outflows should be slowed down.

CASH CONVERSION CYCLE

Calculating the Cash Conversion Cycle

A firm’s operating cycle (OC) is the time form the beginning of the production process to collection of cash from the sale of
the finished product. The operating cycle encompasses two major short-term asset categories: inventory and accounts
receivable. It is measured in elapsed time by summing the average age of inventory (AAI) and the average collection period
(ACP).

OC = AAI + ACP

However, the process of producing and selling a product also includes the purchase of production inputs (raw materials) on
account, which results in accounts payable. Accounts payable reduce the number of days a firm’s resources are tied up in the
operating cycle. The time it takes to pay the accounts payable, measured in days, is the average payment period (APP). The
operating cycle less the average payment period is referred to as the cash conversion cycle (CCC). It represents the amount
of time the firm’s resources are tied up. The formula for the cash conversion cycle is

CCC = OC – APP

Substituting the relationship in equation 1 into Equation 2, we can see that the cash conversion cycle has three main
components: (1) average age of inventory, (2) average collection period, and (3) average payment period.

CCC = AAI + ACP – APP

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MANAGEMENT OF RECEIPTS AND DISBURSEMENTS

Float

Float means delay. It refers to funds that have been sent by the payer but are not yet usable funds to the payee. Float is
important in the cash conversion cycle because its presence lengthens both the firm’s average collection period and its average
payment period. However, the goal of the firm should be to shorten its average collection period and lengthen its average
payment period. Both can be accomplished by managing float.

Float has three component parts:

1. Mail float is the time delay between when payment is placed in the mail and when it is received.
2. Processing float is the time between receipt of the payment and its deposit into the firm’s account.
3. Clearing float is the time between deposit of the payment and when spendable funds become available to the firm.
This component of float is attributable to the time required for a check to clear the banking system.

Speeding Up Collections

Speeding up collections reduces customer collection float and thus reduces the firm’s average collection period, which reduces
the investment the firm must make in its cash conversion cycle.

A popular technique for speeding up collections is a lockbox system. A lockbox system works as follows: Instead of mailing
payments to the company, customers mail payments to a post office box. The firm’s bank empties the post office box regularly,
processes each payment, and deposits the payments in the firm’s account. Deposit slips, along with payment enclosures, are
sent (or transmitted electronically) to the firm by the bank so that the firm can properly credit customers’ accounts.
Lockboxes are geographically dispersed to match the locations of the firm’s customers. A lockbox system affects all three
components of float. Lockboxes reduce mail time and often clearing time by being near the firm’s customers. Lockboxes reduce
processing time to nearly zero because the bank deposits payments before the firm processes them. Obviously a lockbox
reduces collection float time, but not without a cost; therefore, a firm must perform an economic analysis to determine
whether to implement a lockbox system.

Lockbox systems are commonly used by large firms whose customers are geographically dispersed. However, a firm does not
have to be large to benefit from a lockbox. Smaller firms can also benefit from a lockbox system. The benefit to small firms
often comes primarily from transferring the processing of payments to the bank.

Slowing Down Payments

Float is also a component of the firm’s average payment period. In this case, the float is in the favor of the firm. The firm
may benefit by increasing all three of the components of its payment float. One popular technique for increasing payment
float is controlled disbursing, which involves the strategic use of mailing points and bank accounts to lengthen mail float and
clearing float, respectively. Firms must use this approach carefully, though, because longer payment periods may strain supplier
relations. Slowing down payments through controlled disbursing and other methods is a technique known collectively as
stretching accounts payable.

Cash Concentration

Cash concentration is the process used by the firm to bring lockbox and other deposits together into one bank, often called
the concentration bank. Cash concentration has three main advantages. First, it creates a large pool of funds for use in making
short-term cash investments. Because there is a fixed-cost component in the transaction cost associated with such
investments, investing a single pool of funds reduces the firm’s transaction costs. The larger investment pool also allows the
firm to choose from a greater variety of short-term investment vehicles. Second, concentrating the firm’s cash in one account
improves the tracking and internal control of the firm’s cash. Third, having one concentration bank enables the firm to
implement payment strategies that reduce idle cash balances.

IF THE PROBLEM IS SILENT, USE 360-DAY YEAR

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ILLUSTRATIVE PROBLEMS:

Problem 1 (Cash Conversion Cycle)

If the average age on inventory is 60 days, the average age of accounts receivable is 40 days, and the average age of accounts
payable is 35 days, the length of the cash flow cycle is

SOLUTIONS:

Cash conversion cycle = Operating cycle – Average age of A/P

= Average age of inventory + Average age of A/R – Average age of A/P
= 60 + 40 – 35
= 65 days

Problem 2 (Optimum Transaction Size; Total Cost of Cash)

The management of R Company anticipates P12,500,000 in cash outlays during the coming year. The firm has determined that
it costs P75 to convert marketable securities to cash and vice versa. The marketable securities portfolio currently earns an
12% annual rate of return.

1. What is the optimal transaction size (OTS)?

2. Compute the total cost of cash.

SOLUTIONS:

OTS = 2 x Total cash required x conversion cost

opportunity cost

= [(2 x P12,500,000 x P75) ÷ .12]1/2

= P125,000

No. of conversions or checks issued = Total cash required ÷ OTS

= P12,500,000 ÷ P125,000
= 100 checks

Average cash balance = OTS ÷ 2

= P62,500

ANNUAL COST

Conversion cost (100 x P75) P7,500

Opportunity cost (P62,500 x .12) 7,500
TOTAL COST OF CASH P15,000

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NOTE:
▪ At the OTS, the conversion cost and the opportunity cost are equal.
▪ The OTS is the point in which total costs of cash are the lowest.
▪ If the transaction size is P150,000, compute the total cost of cash. (deviate from the OTS)

ANNUAL COST
Conversion cost
(P12,500,000 ÷ P150,000 ÷ P75) P6,250
Opportunity cost
(P150,000 ÷ 2 x .12) 9,000
TOTAL COST OF CASH P15,250

Problem 3 (Optimum Transaction Size)

A firm needs a total of P30 million in new cash for transaction purposes. The annual interest rate on marketable securities is
10% and the brokerage fee cost per transaction of selling securities to replenish cash is P1,000. What is the firm’s optimal
average cash balance?

SOLUTIONS:

OTS = [(2 x P30,000,000 x P1,000) ÷ .10]1/2

= P774,597

Average cash balance = OTS ÷ 2

= P774,597 ÷ 2
= P387,299

Problem 4 (Lock Box System; Cash Float)

P Company uses a continuous billing system that results in average daily receipts of P750,000. The company treasurer estimates
that a proposed lock-box system could reduce its collection time by 3 days.

a. How much cash would the lock-box system free up for the company?

b. What is the maximum amount that P Company would be willing to pay for the lock-box system if it can earn 6 percent
on available short-term funds?

c. If the lock-box system could be arranged at an annual cost of P45,000, what would be the net gain from instituting
the system?

SOLUTIONS:

a. Total cash freed (3 days x P750,000) = P2,250,000

b. Maximum cost of system (equal to cost savings)

(P2,250,000 x .06) = P135,000

c. Increase in profit (P135,000 – 45,000) = P90,000

Problem 5 (Cash Operating Cycle)

A Company is concerned about managing cash efficiently. On the average, inventories have an age of 90 days, and accounts
receivable are collected in 60 days. Accounts payable are paid approximately 30 days after they arise. The firm spends P30
million on operating-cycle investments each year, at a constant rate. Assume a 360-day year.

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a. Calculate the firm’s operating cycle.

b. Calculate the firm’s cash conversion cycle.

c. Calculate the amount of resources needed to support the firm’s cash conversion cycle.

SOLUTIONS:

a. Operating cycle = Average collection period + Inventory cycle days

= 90 + 60
= 150 days

b. Cash conversion cycle = Operating cycle – Average payment days of A/P

= 150 – 30
= 120 days

c. Financing requirement = P30,000,000 ÷ 360 x 120

= P10,000,000

CASH FLOWS MANAGEMENT

Problem 6 (Cash Float)

T Company has daily cash receipts of P85,000. A recent analysis of its collection indicated that customers’ payments were in
the mail an average of 2.5 days. Once received, the payments are processed in 1.5 days. After payments are deposited, it takes
an average of 3 days for these receipts to clear the banking system.

a. How much collection float (in days) does the firm currently have?

b. If the firm’s opportunity cost is 11%, would it be economically advisable for the firm to pay at an annual fee of P16,500
to reduce collection float by four days?

SOLUTIONS:

Cash collection float = Average daily collection x Total float in days

= P85,000 x (2.5 +1.5 + 3)
= P85,000 x 7
= P595,000

Potential income (P85,000 x 4 x .11) P37,400

Annual cost of reducing the float (16,500)
Net advantage of reducing the float by 4 days P20,900

Problem 7 (Lockbox System)

A firm that has an opportunity cost of 9% is contemplating installation of a lockbox system at an annual cost of P90,000. The
system is expected to reduce mailing time by 2.5 days and reduce clearing time by 1.5 days. If the firm collects P300,000 per
day, determine the net benefit (cost) of installing the lockbox system.

SOLUTIONS:

Benefit of using the lockbox system (P300,000 x 4 days x .09) P108,000

Cost of using the lockbox system (90,000)
Net benefit of using the lockbox system P18,000

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Problem 8 (Concentration Banking)

M Company sells to national market and bills all credit customers from the Makati office. Using a continuous billing system,
the firm has collection of P1.2 million per day. Under consideration is a concentration banking system that would require
customers to mail payments to the nearest regional office to be deposited in local banks. M Company estimates that the
collection period for accounts will be shortened by an average of 2.5 days under this system. The firm also estimates that
annual service charges and administrative costs of P300,000 will result from the proposed system. The firm can earn 14% on
equal risk investments.

a. How much cash will be made available for other uses if the firm accepts the proposed concentration banking system?

b. What savings will the firm realize on the 2.5-day reduction in the collection period?

c. The net benefit (cost) of the concentration banking.

SOLUTIONS:

Cash made available using the concentration banking (P1,200,000 x 2.5 days) P3,000,000

Savings from reducing the collection days (P3,000,000 x .14) P420,000

Savings P420,000
Annual service charge from using the concentration banking (300,000)
Net benefit of using the concentration banking P120,000

Problem 9 (Direct Send)

S Company just received a check in the amount of P800,000 from a customer in Baguio. If the firm processes the check in the
normal manner, the funds will become available in 7 days. To speed up the process, the firm could send an employee to the
bank in Baguio on which the check is drawn to present it for payment. Such action will cause the funds to become available
after 3 days. If the cost of the direct send is P800 and the firm can earn 11% on these funds, calculate the net benefit (cost)
of this system. Use a 365-day year.

SOLUTIONS:

Benefit from accelerating collection P964

(P800,000 x 4/365 x .11)
Cost of accelerating collection through direct send (800)
Net benefit from using the direct send system P164

Problem 10 (Controlled Disbursing)

A large Bulacan firm has annual cash disbursements of P360 million made continuously over the year. Although annual service
and administrative costs would increase by P100,000, the firm is considering writing all disbursement checks on a small bank
in Pangasinan. The firm estimates that this will allow an additional 1.5 days of cash usage. If the firm earns a return on other
equally risky investment of 12%, determine the net advantage (disadvantage) of using this techniques of cash disbursement.

SOLUTIONS:

Benefit from delaying payment P165,000

(P360,000,000 ÷ 360 days x 1.5 days x .11)
Cost of delaying payment (100,000)
Net benefit of delaying payment through controlled disbursing P65,000

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Problem 11 (Compensating Balance)

M Company routinely funds its checking account to cover all checks when written. A thorough analysis of its checking account
discloses that the firm could maintain an average account balance that is 25% below the current level and adequately cover all
checks presented. The average account balance is currently P900,000. If the firm can earn 10% on short-term investments,
what, if any, annual savings would result from maintaining the lower average account balance?

SOLUTIONS:

Annual savings (P900,000 x .25 x .10) P22,500

Problem 12 (Float Management)

A firm has daily cash receipts of P100,000. A bank has offered to reduce the collection time on the firm’s deposits by two
days for a monthly fee of P500. If money market rates are expected to average 6 percent during the year, the net annual
benefit (loss) from having this service is

SOLUTIONS:

Cash received 2 days earlier (P100,000 x 2) P200,000

x .06
Interest income P12,000
Annual payment to the bank (P500 x 12) (6,000)
Net Annual Benefit P6,000

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