1. CDA COLLEGE BUS235: PRINCIPLES OF FINANCIAL ANALYSIS Lecture 10 Lecture 10 Lecturer: Kleanthis Zisimos

2. Lecture Topic List Cash management techniques Cash management techniques Marketable securities Marketable securities The Baumol model The Baumol model Receivables management Receivables management Credit policy, collection policy Credit policy, collection policy Credit periods and standards Credit periods and standards

3. Cash Management Cash is often called a “nonearning asset”. It is needed to pay for labor and raw materials, to buy fixed assets, to pay taxes, to service debt, to pay dividends, and so on. The goal of the cash manager is to minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet, at the same time, to have sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to meet unexpected cash needs. Cash is often called a “nonearning asset”. It is needed to pay for labor and raw materials, to buy fixed assets, to pay taxes, to service debt, to pay dividends, and so on. The goal of the cash manager is to minimize the amount of cash the firm must hold for use in conducting its normal business activities, yet, at the same time, to have sufficient cash (1) to take trade discounts, (2) to maintain its credit rating, and (3) to meet unexpected cash needs.

4. Reasons for holding cash Transactions. Cash balances are necessary in business operations. Payments must be made in cash, and receipts are deposited in the cash account. Transactions. Cash balances are necessary in business operations. Payments must be made in cash, and receipts are deposited in the cash account. Compensation to banks for providing loans and services Compensation to banks for providing loans and services A precautionary balance is held for unforeseen cash fluctuations A precautionary balance is held for unforeseen cash fluctuations A speculative balance is held to enable the firm to take advantage of opportunities that might arise A speculative balance is held to enable the firm to take advantage of opportunities that might arise

5. Cash Management Techniques Effective cash management encompasses proper management of both the cash inflows and the cash outflows of a firm. Effective cash management encompasses proper management of both the cash inflows and the cash outflows of a firm. More specifically, managing cash inflows and cash outflows entails (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) getting available funds to where they are needed and (5) controlling disbursements. More specifically, managing cash inflows and cash outflows entails (1) synchronizing cash flows, (2) using float, (3) accelerating collections, (4) getting available funds to where they are needed and (5) controlling disbursements.

6. Cash Flow synchronization and check clearing process Synchronized Cash Flows is a situation in which inflows coincide with outflows, thereby permitting a firm to hold low transactions balances. Synchronized Cash Flows is a situation in which inflows coincide with outflows, thereby permitting a firm to hold low transactions balances. Check clearing is a process of converting a check that has been written and mailed into cash in the payee account Check clearing is a process of converting a check that has been written and mailed into cash in the payee account

7. Using Float Float is defined as the difference between the balance shown in a firm’s checkbook and the balance on the bank’s records. Float is defined as the difference between the balance shown in a firm’s checkbook and the balance on the bank’s records. Disbursement float is the value of the checks which we have written but which are still being processed and thus have not been deducted from our account balance by the bank. Disbursement float is the value of the checks which we have written but which are still being processed and thus have not been deducted from our account balance by the bank. Collections float is the amount of checks that we have received but which have not yet been credited to our account. Collections float is the amount of checks that we have received but which have not yet been credited to our account. Net Flow is the difference between our checkbook balance and the balance shown on the bank’s books. Net Flow is the difference between our checkbook balance and the balance shown on the bank’s books.

8. Acceleration of Receipts Financial managers have been searching for ways to collect receivables faster since credit transactions began. Although cash collection is the financial manager’s responsibility, the speed with which checks are cleared is dependent on the banking system. Acceleration techniques are: Financial managers have been searching for ways to collect receivables faster since credit transactions began. Although cash collection is the financial manager’s responsibility, the speed with which checks are cleared is dependent on the banking system. Acceleration techniques are: Lockboxes. Lockboxes. Pre – Authorized Debits. Pre – Authorized Debits. Concentration Banking. Concentration Banking.

9. Disbursement Control Efficient cash management requires that both inflows and outflows be effectively managed. Accelerating collections represents one side of cash management, and controlling funds outflows is the flip side. Efficient cash management requires that both inflows and outflows be effectively managed. Accelerating collections represents one side of cash management, and controlling funds outflows is the flip side. Payables Centralization.. Payables Centralization.. Zero – Balances Accounts. Zero – Balances Accounts. Controlled Disbursement Accounts. Controlled Disbursement Accounts.

10. Reasons for holding Marketable securities There are two basic reasons for holding securities: They serve as a substitute for cash balances, They serve as a substitute for cash balances, They are used as a temporary investment. They are used as a temporary investment. Some firms hold portfolios of marketable securities, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. Some firms hold portfolios of marketable securities, liquidating part of the portfolio to increase the cash account when cash outflows exceed inflows. In such situations, the marketable securities could be used as a substitute for transactions balances, for precautionary balances, for speculative balances, or for all three. In such situations, the marketable securities could be used as a substitute for transactions balances, for precautionary balances, for speculative balances, or for all three.

11. Factors Influencing the Choice of Marketable Securities Default Risk. The risk that a borrower will be unable to make interest payments, or to repay the principal amount on schedule, is known as default risk. Default Risk. The risk that a borrower will be unable to make interest payments, or to repay the principal amount on schedule, is known as default risk. Event Risk is the risk that an event will occur that suddenly increases a firm’s default risk. Event Risk is the risk that an event will occur that suddenly increases a firm’s default risk. Interest rate price risk is the risk of declines in bond prices to which investors are exposed due to rising interest rates. Interest rate price risk is the risk of declines in bond prices to which investors are exposed due to rising interest rates. Inflation risk is the risk that inflation will reduce the purchasing power of a given sum of money. Inflation risk is the risk that inflation will reduce the purchasing power of a given sum of money. Marketability risk is the risk that securities cannot be sold easily at close to the quoted market price. Marketability risk is the risk that securities cannot be sold easily at close to the quoted market price.

12. The Baumol model for balancing cash and marketable securities The Baumol model is an economic model that determines the optimal cash balance by using economic ordering quantity concepts. The formula is The Baumol model is an economic model that determines the optimal cash balance by using economic ordering quantity concepts. The formula is Q= √ 2(C)(S) Q= √ 2(C)(S) k Q=optimal amount of cash to be raised C=fixed costs of obtaining a loan or sell securities S=total amount of cash needed during the period K=opportunity cost (interest cost of holding cash)

13. Baumol model- Exercise Finder Ltd faces a fixed cost of 1000 euro to obtain new funds. There is a requirement of 20 000 euro of cash over each period. The interest cost of new funds is 12% and the interest rate earned on short term securities is 9%. How much finance should Finder Ltd raise at a time? Finder Ltd faces a fixed cost of 1000 euro to obtain new funds. There is a requirement of 20 000 euro of cash over each period. The interest cost of new funds is 12% and the interest rate earned on short term securities is 9%. How much finance should Finder Ltd raise at a time?

14. The Miller-Orr model The Miller-Orr model is a more realistic approach and eliminates some of the disadvantages of the Baumol model. The Miller-Orr model is a more realistic approach and eliminates some of the disadvantages of the Baumol model. Q= Lower limit+(spread) Q= Lower limit+(spread) 3 3 Q=optimal amount of cash to be raised Lower limit=The minimum accepted level of cash 1/3 1/3 Spread=3x(3x transaction cost x variance of cash flow) 4 x daily interest rate 4 x daily interest rate

15. Miller-Orr Exercise The following data applies to company A Minimum cash Balance €8000 Minimum cash Balance €8000 Variance of daily cash flows is €4 000 000 Variance of daily cash flows is €4 000 000 Transaction cost is €50 Transaction cost is €50 Interest rate is 0,025% per cent per day Interest rate is 0,025% per cent per day Calculate the optimal cash to be raised

16. Credit or Receivables Management Account receivable is a balance due from a customer Account receivable is a balance due from a customer Firms would, in general, rather sell for cash than on credit, but competitive pressures force most firms to offer credit. Firms would, in general, rather sell for cash than on credit, but competitive pressures force most firms to offer credit. Thus, goods are shipped, inventories are reduced, and an account receivable is created. Thus, goods are shipped, inventories are reduced, and an account receivable is created. Receivables management begins with the decision of whether or not to grand credits and to which percentage on sales Receivables management begins with the decision of whether or not to grand credits and to which percentage on sales

17. The Accumulation of Receivables The total amount of accounts receivable outstanding at any given time is determined by two factors: The total amount of accounts receivable outstanding at any given time is determined by two factors: 1. The volume of credit sales and 2. The average length of time between sales and collections. Accounts Receivable = Credit sales x Length of per day collection period per day collection period

18. Days Sales Outstanding Days Sales Outstanding (DSO) is the average length of time required to collect credit sales. Days Sales Outstanding (DSO) is the average length of time required to collect credit sales. DSO = Receivables DSO = Receivables Annual Sales / 360 Annual Sales / 360 Aging Schedule. A report showing how long accounts receivable have been outstanding; Aging Schedule. A report showing how long accounts receivable have been outstanding;

19. Credit Policy Credit policy consists of these four variables: Credit policy consists of these four variables: 1. The credit period, which is the length of time buyers are given to pay for their purchases. 2. The credit standards, which refer to the minimum financial strength of acceptable credit customers and the amount of credit available to different customers. 3. The firm’s collection policy, which refers to the procedures the firm follows to collect past due accounts. 4. Any discounts given for early payment. Including the discount amount and period.

20. The five Cs System to measure credit quality 1. Character refers to the probability that customers will try to honor their obligations. 2. Capacity is a subjective judgment of customers’ abilities to pay. 3. Capital is measured by the general financial condition of a firm as indicated by an analysis of its financial statements. 4. Collateral is represented by assets that customers may offer as security in order to obtain credit. 5. Conditions refers to both to general economic trends and to special developments in certain geographic regions or sections of the economic that might affect customers’ abilities to meet their obligations.