FIN3 University of St. La Salle

1. Topic Outline
• Cash Management
• Inventory Management
• Accounts Receivable Management

2. Management of Cash and
Marketable Securities

3. Cash doesn’t earn a profit, so why
should the firm hold it?
1. Transactions – must have some cash to
operate.
2. Precaution – “safety stock”. Reduced by
line of credit and marketable securities.
3. Compensating balances – for loans and/or
services provided.
4. Speculation – to take advantage of
bargains and to take discounts. Reduced
by credit lines and marketable securities.

4. • cash is needed to satisfy the transactions
motive
• Another reason to hold cash is for compensating
balances.
• it would not be correct for a firm to add the
amount of cash required to satisfy its transaction
needs to the amount of cash needed to satisfy its
compensatory balances to produce a target cash
balance.

5. The goal of cash management
• To meet the above objectives, especially
to have cash for transactions, yet not
have any excess cash.
• To minimize transactions balances in
particular, and also needs for cash to
meet other objectives.

6. Minimizing cash holdings
• Use a lockbox
• Insist on wire transfers from customers
• Synchronize inflows and outflows
• Use a remote disbursement account
• Reduce need for “safety stock” of cash
– Increase forecast accuracy
– Hold marketable securities
– Negotiate a line of credit

7. Cash budget
• Forecasts cash inflows, outflows, and ending
cash balances.
• Used to plan loans needed or funds available
to invest.
• Can be daily, weekly, or monthly, forecasts.
– Monthly for annual planning and daily for actual
cash management.

8. Managing Receipts and Disbursements
• Receipts
– Cash must be deposited to the bank account at
the shortest time with the minimum cost
– Internal controls
– Efficient reporting system that allows real time
updating
• Disbursements
– Centralization of payments
– Playing the float
– Cross checking of all payments

9. Determining Optimum Cash Balance
• Baumol Model
– Expenditures occur evenly throughout the
period.
– Holding cost for cash is the income foregone
on the cash held or the cost of financing the
cash balance.
– Short term investments are alternatives to
cash

11. Baumol Model

12. Baumol Model

13. • Aubrey Company has a daily demand for cash
of $4,000, or $1,460,000 annually. Short-term
investments earn 5% annually. The interest
rate on Aubrey’s line of credit is 8%, while the
cost to convert marketable securities to cash is
$50 per transaction. The optimal value of C for
each cash management cycle is:

15. Illustration
• UP Foundation pays honorarium to 500
faculty members at P30,000 per year per
faculty. Investments in short term securities
earn 13% and cost per transfer is estimated
at P500.
a.How much should be the optimal size of cash
transfer?
b.How much is the total cost of cash transfer?

16. Disadvantages of Baumol Model
• Assumes stable and predictable cash flows
• Does not take into account seasonal
fluctuations

17. • Most firms don’t use their cash flows
uniformly and also cannot predict their daily
cash inflows and outflows. Mille-Orr Model
helps them by allowing daily cash flow
variation.

18. Miller-Orr Model
The distribution of the daily cash changes is at
least approximately normal.
The transfer cost between cash and the portfolio
is at a given fixed cost
The transfer between cash and the portfolio can
be implemented instantaneously
The minimum cash balance is determined outside
the model and depends on the ability of the firm
to source funds externally as required.
Determining Optimum Cash Balance

19. Miller-Orr Model
 Does not set a single valued target cash but
rather a range within which the cash balance is to
be maintained.
 Seeks to minimize the expected cost of holding
cash by making sure that cash balance does not
exceed the upper limit nor fall below the lower
limit.
 Cash Return Point is the level to which cash is to
be adjusted whenever cash holdings falls below
the lower limit or exceeds the upper limit.

21. • The lower limit is set by the firm based on its
desired minimum “safety stock” of cash in hand
The firm should also determine the following
factors:
• 1. An interest rate for marketable securities, (i)
• 2. A fixed transaction cost for buying and selling
marketable securities, (c)
• 3. The standard deviation if its daily cash flows,
(s)

22. Miller-Orr Model

23. Miller-Orr Model
• UL = 3z + LL
• Illustration
– The company has found the standard deviation of
its daily cash flow to be P30,983.87. The
company’s transfer cost from investment to cash
and vice versa is P500 per transfer. The current
interest rate on short term investments is 13%.
The financing company has set a lower limit at
P50,000.

25. • To use the Miller–Orr model, the manager must
do four things:
• 1 Set the lower control limit for the cash balance.
This lower limit can be related to a minimum
safety margin decided on by management.
• 2 Estimate the standard deviation of daily cash
flows.
• 3 Determine the interest rate.
• 4 Estimate the trading costs of buying and selling
marketable securities

26. • These four steps allow the upper limit and
return point to be computed. Miller and Orr
tested their model using nine months of data
for cash balances for a large industrial firm.
The model was able to produce average daily
cash balances much lower than the averages
actually obtained by the firm.

27. Inventory Management

28. Inventory Management Techniques
• ABC Inventory System
– Inventory management technique that divides
inventory into three groups— A, B, and C, in
descending order of importance and level of
monitoring, on the basis of the dollar investment
in each.
• EOQ Model
– Inventory management technique for determining
an item’s optimal order size, which is the size that
minimizes the total of its order costs and carrying
costs.

29. Inventory Management Techniques
• JIT System (Just in Time)
– Inventory management technique that
minimizes inventory investment by having
materials arrive at exactly the time they are
needed for production
• Computerized Systems for Resource
Control

30. EOQ Model
Where: S = usage in Units per period
O = order cost per order
C = Carrying Cost per unit per period
Q = Order quantity in units
At EOQ, Carrying Cost = Ordering Cost
Carrying cost = C x (Q / 2)
Order Cost = O x (S / Q)
Total Cost = Carrying Cost + Order Cost

31. Accounts Receivable
Management

32. Elements of credit policy
1. Credit Period – How long to pay? Shorter
period reduces DSO and average A/R, but it
may discourage sales.
2. Cash Discounts – Lowers price. Attracts new
customers and reduces DSO.
3. Credit Standards – Tighter standards tend to
reduce sales, but reduce bad debt expense.
Fewer bad debts reduce DSO.
4. Collection Policy – How tough? Tougher policy
will reduce DSO but may damage customer
relationships.

33. Does SKI face any risk if it tightens its
credit policy?
• Yes, a tighter credit policy may discourage
sales.
– Some customers may choose to go elsewhere
if they are pressured to pay their bills sooner.
– SKI must balance the benefits of fewer bad
debts with the cost of possible lost sales.

34. If SKI reduces its DSO without adversely
affecting sales, how would this affect its
cash position?
• Short run: If customers pay sooner, this
increases cash holdings.
• Long run: Over time, the company would
hopefully invest the cash in more
productive assets, or pay it out to
shareholders. Both of these actions
would increase EVA.