OVERVIEW
Objective
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To understand the importance of cash flow and methods of controlling cash flows, the theoretical models relating to optimal cash balances and the importance of treasury management.TREASURY MANAGEMENT
OPTIMAL CASH BALANCES BORROWING IN
THE SHORT-TERM
¾ Advantages of centralised treasury management
¾ The role of the treasurer ¾ Cash flow budgeting
¾ Sensitivity analysis in cash budgeting
¾ Sources
INVESTING IN THE SHORT-TERM
¾ Why do surplus funds arise? ¾ Investing surplus funds –
factors to consider ¾ Short-term investments
¾ EOQ (Baumol) model
¾ Miller-Orr model
CASH MANAGEMENT
1
CASH MANAGEMENT
1.1
Reasons for holding cash
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Transactions motive – to provide sufficient liquidity to meet current day-to-day financial obligations, e.g. payroll, the purchase of raw materials, etc.¾
Precautionary motive – a cash reserve to give a cushion against unplanned expenditure, rather like buffer/safety level of inventory. This reserve may be held in the form of “cash equivalents” - short-term, low risk, highly liquid investments e.g. treasury bills.¾
Speculative motive – to quickly take advantage of investment opportunities that may arise e.g. some firms build a “war chest’ of cash ready to use if a suitable takeover target appears.However it is important that a firm does not hold excessive levels of cash as this leads to inefficiency. Cash balances belong to the shareholders who are expecting to receive significant return on their investment in the firm.
Any long-term surplus of cash should therefore be either reinvested into positive NPV projects or returned to shareholders via:
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Dividends – possibly as a “special” dividend, or¾
Share buy-back programme1.2
Cash and profits
Profits are accounted for on an accruals basis and a company must be profitable to continue in existence. However, profitability is not enough; companies must also have enough cash flow available to meet all their day to day payments and longer-term commitments in order to survive.
2
TREASURY MANAGEMENT
Definition
The efficient management of liquidity and risk in a business including the management of funds (generated from internal and external sources), currencies and cash flow.
2.1
Advantages of centralised treasury management
These include:
9
Management by specialised staff;9
Economies of scale e.g. less staff required in total ;9
“Pooling” - netting cash deficits against surpluses in order to save interest expense.9
Increased negotiating power with banks;9
More efficient foreign exchange risk management - the treasury department at head office can find the group’s net position on each currency and then consider an external hedge on this balance.Within a treasury department of a large company there may still be a degree of decentralisation in order to ensure that the decisions taken are appropriate to local circumstances.
2.2
The role of the treasurer
To have the right amount of cash available at the right time the treasurer will be involved in:
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accurate cash flow forecasting, so that shortfalls and surpluses can be anticipated;¾
planning short-term borrowing when necessary;¾
planning investments of surpluses when necessary;¾
cost efficient cash transmission;¾
dealing with foreign currency issues;¾
optimising banking arrangements;¾
planning major finance-raising exercises;¾
accounts receivable/accounts payable policies.In addition, the treasurer is often involved in risk assessment and insurance.
2.3
Cash flow budgeting
A major task of the treasurer is cash flow budgeting. A simple pro-forma is given below:
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Forecast:– Sales volume; – Revenue; – Costs;
– One-off expenses (e.g. capital expenditure).
Q1 Q2 Q3 Q4 Total
Capital expenditure/leases x x
Interest/principal on debt x x x x x
2.4
Sensitivity analysis in cash budgeting
¾
Sensitivity analysis answers the question “What if?” and can be used to deal with uncertainty in cash budgeting.¾
The effect on net cash flows per month or quarter could be examined in the following ways: Considering changes in payment patterns by credit customers. Best-case and worst- case scenarios should be examined.
Allowing for changes in the timing of other receipts, e.g. sale of fixed assets, rights issues, debt issues, etc.
Considering changes in materials costs. If prices are uncertain, a worst-case scenario should be examined.
Allowing for changes in other costs (e.g. labour, overheads) or timings of outflows (e.g. fixed overhead payments, dividends, capital expenditure).
3
BORROWING IN THE SHORT-TERM
Having completed a cash flow forecast the treasurer may identify a requirement to borrow funds in the short term.
3.1
Sources of short-term borrowing
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Debt factoring and invoice discounting;¾
Bank overdraft - however: technically repayable on demand (although the bank may offer a “revolving line of credit”);
normally carries a flat charge for the facility and high variable interest rate on the balance.
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Short-term loans: may require security
can have fixed or variable rates of interest.
4
INVESTING IN THE SHORT-TERM
Alternatively a treasurer may discover that the company has a cash surplus for a short-term period.
4.1
Why do surplus funds arise?
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Over funding – proceeds which are not yet fully required may have already been received from a share/debt issue;¾
Disposal of surplus assets or divisions;¾
Operating surpluses.4.2
Investing surplus funds — factors to consider
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Amount of funds available.¾
Liquidity – how quickly can the investment be converted back into cash?¾
Risk – the treasurer should not gamble with the shareholders’’ funds¾
Return on the proposed investment – obviously this will be limited by the requirement to select low risk investments.4.3
Short-term investments
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Money market deposits i.e.-bank deposits. There may be a notice period forwithdrawals and therefore should only be used if there is high certainty of cash flows.
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Certificate of deposit - negotiable deposits issued by banks and building societies, maturities from 28 days to 5 years. The holder can sell the certificate before its maturity date, hence more liquid than money market deposits but lower returns.¾
Treasury bills – 2, 3, and 6 month UK government debt, very low risk and very liquid, but even lower returns.¾
Gilt-edged government securities (“gilts”) – the long term version of Treasury Bills with maturities usually greater than 5 years. It is not recommended that short-term cash surpluses are invested in newly issued gilts as their market prices are very sensitive to interest rate changes. It would be more sensible to invest in gilts which are close to maturity¾
Other government bonds – for example UK local authority bonds, rates tied to money markets, good liquidity.¾
Certificates of tax deposit – deposits with UK Inland Revenue that may be surrendered for cash or used in settlement of tax liabilities.¾
Commercial paper – short term (7 days - 3 months) unsecured debts issued by high quality companies, good liquidity¾
Corporate bonds - longer maturity fixed interest securities issued by the corporate sector. Liquidity can be poor and risk higher than on government bonds or commercial paper.¾
Equities – investing short term cash surpluses on the stock market is not recommended as high risk.¾
Non-sterling instruments - most of the above have non-sterling counterparts, e.g. US Treasury bills, etc; beware exchange risk.Commentary
5
OPTIMAL CASH BALANCES
Is there an optimal cash balance?Two theoretical models will now be considered.
5.1
EOQ (Baumol) model
5.1.1
Assumptions
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This model applies the EOQ model to cash. It assumes that that cash requirements are funded by the sale of “parcels” of securities e.g. Treasury Bills.¾
The model calculates the optimal size for the “parcel” of securities. This is known as the “economic transfer”.5.1.2
Formula
s = cash needs for the period
f = transaction costs (brokerage, commission etc) of selling a “parcel” of securities
h = Opportunity cost of holding cash (interest forgone on securities)
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Economic transfer = h 2fs5.1.3
Weaknesses
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Uncertainty - demand for cash is not constant.¾
The model assumes that the business is constantly using cash and must finance this by selling investments. However any worthwhile business must at some point generate cash rather than “burn” it.Illustration 1
A firm has large deposits which currently attract interest of 15%. It has cash needs of $300,000 in the next year.
Transaction costs are $120.
Solution
s = 300,000 f = 120 h = 0.15
Economic transfer
=
0.15 300,000 120
2× ×
= $21,909
Average balance = 2
$21,909 = $10,954
5.2
Miller-Orr model
Cash
balance Upper limit
Return point
Lower limit
Time convert investments back into cash make investments
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Lower limit - represents the “safety” level of cash and is set by management. If cash falls to this level then sell short-term investments to return the cash balance to the Return Point.¾
Upper limit - the maximum level of cash to hold. Once the cash balance reaches the upper limit, short-term investments should be bought in order to bring the cash balance back down to the Return Point.¾
Return Point – the level to which cash balances should be brought if they reach the upper or lower limit.¾
The model is particularly useful when cash flows are uncertain.¾
The following formulae are provided in the examination : Spread = the difference between the upper limit and lower limit
Transaction costs = the fixed cost of buying or selling marketable securities Variance = variance of the net daily cash flows
Interest rate = daily interest rate on marketable securities i.e. the daily opportunity cost of holding cash
Example 1
A company requires a minimum cash balance of $6000 and the variance of daily cash flows is estimated to be $2,250, 000. The interest rate on securities is 0.025% per day and the transaction cost for each sale or purchase of securities is $20. and interpret the results.
Key points
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The only reason for a business to exist is if it can generate positive cash flows from operations.³
However cash surpluses should not simply be left in the company’s bank account as this produces a very low return. Long term surpluses should be invested into positive NPV projects, or used to pay a dividend.³
Short –term surpluses should be invested in low risk, highly liquid investments such as Treasury Bills. The Baumol and Miller-Orr models provide detailed models on how to manage transactions between cash and short-term investments.FOCUS
You should now be able to:
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explain the role of cash in the working capital cycle;¾
describe the functions of and evaluate the benefits from centralised cash control and treasury management;EXAMPLE SOLUTION
Upper limit = lower limit + spread = 6,000 + 15,390
