Cash and Marketable Securities Management

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Chapter 9

Cash and Marketable Securities

Management

Cash and Marketable Securities

Management

Muhammad Afzal, NTI

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After studying Chapter 9, you should be able to:

List and explain the motives for holding cash. Understand the purpose of efficient cash management. Describe methods for speeding up the collection of accounts receivable

and methods for controlling cash disbursements. Differentiate between remote and controlled disbursement, and discuss

any ethical concerns raised by either of these two methods. Discuss how electronic data interchange (EDI) and outsourcing each

relates to a company’s cash collections and disbursements. Identify the key variables that should be considered before purchasing

any marketable securities. Define the most common money-market instruments that a marketable

securities portfolio manager would consider for investment. Describe the three segments of the marketable securities portfolio and

note which securities are most appropriate for each segment and why.

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Cash and Marketable Securities Management

Motives for Holding Cash Speeding Up Cash Receipts S-l-o-w-i-n-g D-o-w-n

Cash Payouts Electronic Commerce

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Cash and Marketable Securities Management

Outsourcing Cash Balances to Maintain Investment in Marketable

Securities

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Motives for Holding Cash

Transactions Motive -- to meet payments arising in the ordinary course of business

Speculative Motive -- to take advantage of temporary opportunities

Precautionary Motive -- to maintain a cushion or buffer to meet unexpected cash needs

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Cash Management System

Collections Disbursements

Marketable securitiesinvestment

Control through information reporting

= Funds Flow = Information Flow

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Speeding Up Cash Receipts

Expedite preparing and mailing the invoice

Accelerate the mailing of payments from customers

Reduce the time during which payments received by the firm remain uncollected

Collections

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Collection Float

Collection Float: total time between the mailingof the check by the customer and the availability

of cash to the receiving firm.

ProcessingFloat

AvailabilityFloat

MailFloat

Deposit Float

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Mail Float

Mail Float: time the check is in the mail.

Customer mails check

Firmreceives check

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Processing Float

Processing Float: time it takes a companyto process the check internally.

Firmdeposits check

Firmreceives check

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Availability Float

Availability Float: time consumed in clearingthe check through the banking system.

Firmdeposits check

Firm’s bankaccount credited

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Deposit Float

Deposit Float: time during which the check received by the firm remains uncollected funds.

Processing Float Availability Float

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Earlier Billing

Accelerate preparation and mailing of invoices

computerized billing invoices included with shipment invoices are faxed advance payment requests preauthorized debits

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Preauthorized Payments

Preauthorized debit

The transfer of funds from a payor’s bank account on a specified date to

the payee’s bank account; the transfer is initiated by the payee

with the payor’s advance authorization.

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Lockbox Systems

Traditional LockboxA post office box maintained by a firm’s bank that is used as a receiving point for customer

remittances.

Electronic LockboxA collection service provided by a firm’s bank

that receives electronic payments and accompanying remittance data and

communicates this information to the company in a specified format.

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Lockbox Process*

Customers are instructed to mail their remittances to the lockbox location.

Bank picks up remittances several times daily from the lockbox.

Bank deposits remittances in the customers account and provides a deposit slip with a list of payments.

Company receives the list and any additional mailed items.

* Based on the traditional lockbox system

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Lockbox System

Disadvantage

Cost of creating and maintaining a lockbox system. Generally, not

advantageous for small remittances.

Advantage

Receive remittances sooner which reduces processing float.

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Concentration Banking

Compensating BalanceDemand deposits maintained by a firm

to compensate a bank for services provided, credit lines, or loans.

Cash Concentration

The movement of cash from lockbox or field banks into the firm’s central cash pool residing in a concentration bank.

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Concentration Banking

Improves control over inflows and outflows of corporate cash.

Reduces idle cash balances to a minimum.

Allows for more effective investments by pooling excess cash balances.

Moving cash balances to a central location:

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Concentration Services for Transferring Funds

Definition: A non-negotiable check payable to a single company account at a concentration bank.

Funds are not immediately available upon receipt of the DTC.

(1) Depository Transfer Check (DTC)

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Definition: An electronic version of the depository transfer check (DTC).

(1) Electronic check image version of the DTC.

(2) Cost is not significant and is replacing DTC.

(2) Automated Clearinghouse (ACH) Electronic Transfer

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Definition: A generic term for electronic funds transfer using a two-way communications system, like Fedwire.

Funds are available upon receipt of the wire transfer. Much more expensive.

(3) Wire Transfer

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S-l-o-w-i-n-g D-o-w-n Cash Payouts

“Playing the Float” Control of Disbursements

Payable through Draft (PTD) Payroll and Dividend

Disbursements Zero Balance Account (ZBA)

Remote and Controlled Disbursing

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“Playing the Float”

You write a check today, which is subtracted from your calculation of the account balance.

The check has not cleared, which creates float. You can potentially earn interest on money that

you have “spent.”

Net Float -- The dollar difference between the balance shown in a firm’s (or

individual’s) checkbook balance and the balance on the bank’s books.

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Control of Disbursements

Solution:

Centralize payables into a single (smaller number of) account(s). This provides better

control of the disbursement process.

Firms should be able to:

1. shift funds quickly to banks from which disbursements are made.

2. generate daily detailed information on balances, receipts, and disbursements.

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Methods of Managing Disbursements

Delays the time to have funds on deposit to cover the draft.

Some suppliers prefer checks. Banks will impose a higher service charge

due to the additional handling involved.

Payable Through Draft (PTD):A check-like instrument that is drawn against the payor and not against a bank as is a check. After

a PTD is presented to a bank, the payor gets to decide whether to honor or refuse payment.

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Many times a separate account is set up to handle each of these types of disbursements.

A distribution scheduled is projected based on past experiences. [See slide 9-28]

Funds are deposited based on expected needs. Minimizes excessive cash balances.

Payroll and Dividend DisbursementsThe firm attempts to determine when payroll and dividend checks will be presented for collection.

9-28

Percentage of Payroll Checks Collected

F M T W H F M and after(Payday)

Per

cen

t o

fP

ayro

ll C

oll

ecte

d

100%

75%

50%

25%

0%

The firm may plan onpayroll checks beingpresented in a similar

pattern every pay period.

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Eliminates the need to accurately estimate each disbursement account.

Only need to forecast overall cash needs.

Zero Balance Account (ZBA):A corporate checking account in which a zero balance is maintained. The account requires a master (parent) account from which funds are drawn to cover negative balances or to which

excess balances are sent.

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Example: A Vermont business pays a Maine supplier with a check drawn on a bank in Montana.

This may stress supplier relations, and raises ethical issues.

Remote Disbursement -- A system in which the firm directs checks to be drawn on a bank

that is geographically remote from its customer so as to maximize check-clearing time.

This maximizes disbursement float.

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Late check presentments are minimal, which allows more accurate predicting of

disbursements on a day-to-day basis.

Controlled Disbursement -- A system in which the firm directs checks to be drawn on a bank (or branch bank) that is able to give early or mid-morning notification of the total dollar amount of checks that will

be presented against its account that day.

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Electronic Commerce

Messaging systems can be:1. Unstructured -- utilize technologies

such as faxes and e-mails 2. Structured -- utilize technologies such

as electronic data interchange (EDI).

Electronic Commerce -- The exchange of business information in an electronic (non-paper) format, including over the Internet.

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Electronic Data Interchange (EDI)

Electronic Data Interchange -- The movement of business data electronically

in a structured, computer-readable format.

EDIElectronic Funds Transfer (EFT)

Financial EDI (FEDI)

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Electronic Funds Transfer (EFT)

Electronic Funds Transfer (EFT) -- the electronic movements of information between two

depository institutions resulting in a value (money) transfer.

EDISubset


Society of Worldwide Interbank Financial Telecommunications (SWIFT)

Clearinghouse Interbank Payments System (CHIPS)

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New Regulation

In January 1999, a new regulation requires ALL federal government payments be made electronically.* This will:

• provide more security than paper checks and• be cheaper to process for the government.

* Except tax refunds and special waiver situations

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Financial EDI -- The movement of financially related electronic information between a

company and its bank or between banks.


Examples include:

Lockbox remittance information

Bank balance information

EDISubset

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Costs and Benefits of EDI

Costs Computer hardware and

software expenditures Increased training costs

to implement and utilize an EDI system

Additional expenses to convince suppliers and customers to use the electronic system

Loss of float

Benefits Information and payments

move faster and with greater reliability

Improved cash forecasting and cash management

Customers receive faster and more reliable service

Reduction in mail, paper, and document storage costs

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Outsourcing

1. Improving company focus2. Reducing and controlling operating

costs 3. Freeing resources for other purposes

* The Outsourcing Institute, 2002

Outsourcing -- Subcontracting a certain business operation to an outside firm,

instead of doing it “in-house.”

Why might a firm outsource?*

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Cash Balances to Maintain

The optimal level of cash should be the larger of:

(1) the transaction balances required when cash management is efficient.

(2) the compensating balance requirements of commercial banks.

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Investment in Marketable Securities

Marketable Securities are shown on the balance sheet as:

1. Cash equivalents if maturities are less than three (3) months at the time of acquisition.

2. Short-term investments if remaining maturities are less than one (1) year.

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The Marketable Securities Portfolio

Ready Cash Segment (R$)

Optimal balance of marketable securities

held to take care of probable deficiencies

in the firm’s cash account.

R$F$

C$

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Controllable Cash Segment (C$)

Marketable securities held for meeting

controllable (knowable) outflows,

such as taxes and dividends.


R$F$

C$

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Free Cash Segment (F$)

“Free” marketable securities (that is, available for as yet

unassigned purposes).


R$F$

C$

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Variables in Marketable Securities Selection

Marketability (or Liquidity)The ability to sell a significant volume of securities in a short period of time in the

secondary market without significant price concession.

SafetyRefers to the likelihood of getting back the

same number of dollars you originally invested (principal).

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Variables in Marketable Securities Selection

Maturity

Refers to the remaining life of the security.

Interest Rate (or Yield) Risk

The variability in the market price of a security caused by changes in

interest rates.

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Common Money Market Instruments

Treasury Bills (T-bills): Short-term, non-interest bearing obligations of the U.S. Treasury issued at a discount and redeemed at maturity for full face value. Minimum $1,000 amount and $1,000 increments thereafter.

Money Market InstrumentsAll government securities and short-term corporate obligations. (Broadly defined)

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T-Bills and Bond Equivalent Yield (BEY) Method:

BEY = [ (1000 – 990) / (990) ] *[ 365 / 91 ]

BEY = 4.05%

BEY = [ (FA – PP) / (PP) ] *[ 365 / DM ]• FA: face amount of security• PP: purchase price of security• DM: days to maturity of security

A $1,000, 13-week T-bill is purchased for $990 – what is its BEY?

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T-Bills and Equivalent Annual Yield (EAY) Method:

EAY = (1 + [.0405/(365 / 91)])365/91 - 1

EAY = 4.11%

EAY = (1 + [ BEY / (365 / DM) ] )365/DM - 1• BEY: bond equivalent yield from the previous slide• DM: days to maturity of security

Calculate the EAY of the $1,000, 13-week T-bill purchased for $990 described on the previous slide?

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Treasury Bonds: Long-term (more than 10 years’ original maturity) obligations of the U.S. Treasury.

Treasury Notes: Medium-term (2-10 years’ original maturity) obligations of the U.S. Treasury.

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Bankers’ Acceptances (BAs): Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity.

Repurchase Agreements (RPs; repos): Agreements to buy securities (usually Treasury bills) and resell them at a higher price at a later date.

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Federal Agency Securities: Debt securities issued by federal agencies and government-sponsored enterprises (GSEs). Examples: FFCB, FNMA, and FHLMC.

Commercial Paper: Short-term, unsecured promissory notes, generally issued by large corporations (unsecured IOUs). The largest dollar-volume instrument.

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Negotiable Certificate of Deposit: A large-denomination investment in a negotiable time deposit at a commercial bank or savings institution paying a fixed or variable rate of interest for a specified period of time.

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Money Market Preferred Stock: Preferred stock having a dividend rate that is reset at auction every 49 days.

Eurodollars: A U.S. dollar-denominated deposit -- generally in a bank located outside the United States -- not subject to U.S. banking regulations

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Selecting Securities for the Portfolio Segments

Ready Cash Segment (R$)

Safety and ability to convert to cash is most important.

Select U.S. Treasuries for this

segment.

R$F$

C$

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Controllable Cash Segment (C$)

Marketability less important. Possibly match time needs.

May select CDs, repos, BAs, euros for

this segment.

R$F$

C$


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Free Cash Segment (F$)

Base choice on yield subject to risk-return

trade-offs.

Any money market instrument may be

selected for this segment.

R$F$

C$


Cash and Marketable Securities Management

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