Chapter 5Cash and

Marketable Securities

Management

IntroductionO Cash – The currency and coin the firm has on

hand in petty cash drawers, in cash registers or in checking accounts at various commercial banks

O Cash is the most liquid asset and often called as “non earning asset” due to its holdings give no return but are needed to meet its maturing obligations. Without cash the firm cannot operate. Thus its crucial to hold min amount of cash sufficiently to support firm’s normal business activities.

Reasons for Holding Cash

O Transaction motive – cash for transaction balances to meet obligations or payments arise in the ordinary course of doing business. E.G. purchase materials, pay bills

O Precautionary motive – act as a buffer to meet unforeseen events, which require immediate cash payment. This may arise due to risk and uncertainty. (taking advantage of investment opportunity)

Cont.O Speculative Motive – to hold sufficient

liquid assets to enable the firm to take advantage of any unexpected bargain purchase that may arise anytime

O Compensating balances – to compensate FI for providing loans and services. Required firms to maintain min level of money in its bank’s a/c. (normally based on certain % of the loans taken)

Cash ManagementO GOAL - To minimize cash balance while maintaining

certain level of liquidity

O HOW ?

– Cash flow mgt – speed up collections , slow down disbursements and maintain good banking relationship to ease all transactions.

- Prepare cash budget in order to determine the optimal cash balance

- Develop borrowing or investment strategies (use idle temporary liquidity and earn return concept)

? To determine Minimum Operating Cash (MOC)O MOC – to allow the firm to invest in

various alternatives and repay its debts when they are due.

O Cash balances and safety stock of cash are influenced by firm’s production, sales techniques, procedure for collecting sales receipt and payment for purchases or known as Operating Cycle (OC) and Cash Cycle (CC).

Operating CycleO The length of time between the purchase of raw material

and time cash is collected from sales of finished goods or receivables

O Formula : OC = AAI + ACPO Where;

*AAI (Average Age of Inventory) – The average length of time goods is in inventory

*ACP (Average Collection Period) – the average number of days customers take to pay

Cash CycleO Cash Cycle (CC)

O The lag time between cash outlay to purchase raw materials or inventories and cash is collected from receivables (overall period between the time cash is paid out to suppliers & cash is received from customers).

O CC = Operating Cycle (OC) – APP = [AAI + ACP] – APP

APP (Average Payment Period) – The average numbers of days the firm take to pay for the purchase of raw materials

ValuationO Cash Turnover (CTO)

O Measure how effective cash is managed in the firmO The number of times the firm’s cash is actually turned

over each yearO Shorter OC and CC will result to higher CTO.

O CTO = 360 / Cash Cycle

ValuationO Minimum Operating Cash (MOC)Minimum Operating Cash (MOC)

O Amount of cash that need to be held at any given time to support operations

O Lower MOC requirements will lower investment in cash to support firm’s operations

O MOC = Annual cash outlays / Cash Turnover

QUESTION

Cik Shasha is planning to determine the firm’s minimum operating cash to reduce the firm’s cost of investment. Currently the firm is holding RM110,000 cash on average continuously. The firm is selling on terms net 45. All customers normally pay on the last day.

The firm pays all credit purchases on net 30. The firm takes 40 days to produce and 20 days to sell the products. The firm’s yearly cash outlay is RM500,000. (Use 360 days in a year)

QUESTION

a) Calculate the cash cycle, cash turnover and the minimum operating cash.

b) Is the current cash holding sufficient to meet its need ? Why?

a) CC = AAI + ACP – APP

= 60 + 45 – 30 = 75 DAYS

CTO = 360 / 75

= 4.8x

MOC = 500 000 / 4.8

= RM104,166.67

b) Yes, its sufficient since cash holding > Minimum Operating Cash (MOC)

Marketable Securities (MS) Management

O MS are liquids as cash – it takes relatively short time for its conversion to cash without losing the face value.

O 2 reasons for holding MS:O a) Substitute for cash – precautionary

purposes as a cushion against unexpected shortage of bank credit (eg. OD) or other emergency cash outflows

Cont.O b) Temporary investment – firm’s

cash receipts rarely match its disbursement thus, to finance seasonal needs for cash and to meet known future financial requirements

O MS portfolio differs in terms of: maturity, liquidity and returns.

Factors that influencing the choice of marketable securities

O Liquidity risk – the ability to transform securities into cash without experiencing a loss in value

O Purchasing power – the risk that inflation will reduce the purchasing power of a given sum of money

O Interest rate risk – the risk to which investors are exposed due to rising interest rate

Cont.O Default risk – the risk that an issuer will be unable

to make interest payment or repay the principal amount a schedule

O Return on securities – Higher return is required on these securities, but the company must be brave enough to face a higher risk.

Marketable securitiesO Def : security investments that the firm can quickly

converted into cash balance.

O 2 types of MS :O Private issueO Government issue

Marketable Securities –Private Issue

O Negotiable certificate of deposit (NCDs) – A marketable receipts for funds that have been deposited in a bank for a fixed period

O Commercial Paper – A short term, unsecured promissory notes sold by large business to raise cash

O Banker’s Acceptance – A draft (order to pay) drawn on a specific bank by an exporter in order to obtain payment for goods shipped to a customer, who maintains an account with specific bank.

Marketable Securities-Government Issue

O Treasury Bills – Lowest risk due to risk free. Mostly mature in 91-182 days with longer maturity such as 9 months or 1 year. In denomination of RM1,000.

O Treasury notes – US Treasury obligation with initial obligation with initial maturities between 1 to 7 years