CASH MANAGEMENT BASIC DEFINITION AND TUTORIALS

What Is Cash? How To Manage Cash?

Cash refers to currency and demand deposits. Cash management involves having the optimum, neither excessive nor deficient, amount of cash on hand at the right time. Proper cash management requires that the company know how much cash it needs, as well as how much it has and where that cash is at all times.

This is especially essential in an inflationary environment. The objective of cash management is to invest excess cash for a return while retaining sufficient liquidity to satisfy future needs. The financial manager must plan when to have excess funds available for investment and when money needs to be borrowed.

The amount of cash to be held depends upon the following factors:
1. Cash management policies
2. Current liquidity position
3. Management’s liquidity risk preferences
4. Schedule of debt maturity
5. The firm’s ability to borrow
6. Forecasted short- and long-term cash flow
7. The probabilities of different cash flows under varying circumstances

The company should not have an excessive cash balance since no return is being earned upon it. The least amount of cash a firm should hold is the greater of (1) compensating balances (a deposit held by a bank to compensate it for providing services) or (2) precautionary balances (money held for emergency purposes) plus transaction balances (money needed to cover checks outstanding).

Cash management also requires knowing the amount of funds available for investment and the length of time for which they can be invested. A firm may invest its funds in the following:

1. Time deposits, including savings accounts earning daily interest, long-term savings accounts, and certificates of deposit

2. Money market funds, which are managed portfolios of short-term, high-grade debt instruments such as Treasury bills and commercial paper

3. Demand deposits that pay interest

4. U.S. Treasury securities


When cash receipts and disbursements are highly synchronized and predictable, a firm may keep a small cash balance. The financial manager must accurately forecast the amount of cash needed, its source, and its destination. These data are needed on both a short- and a long-term basis.

Forecasting assists the manager in properly timing financing, debt repayment, and the amount to be transferred between accounts.

In deciding whether to adopt a cash management system, the financial manager should consider its associated costs versus the return earned from implementation of the system. Costs related to cash management systems include bank charges, financial manager’s time, and office employee salaries.

Some cash management systems use the firm’s computer to make transactions with the computers of banks and money market funds. Computer systems are also useful for purchasing and selling securities in the money market.

Companies with many bank accounts should guard against accumulating excessive balances. Less cash needs to be kept on hand when a company can borrow quickly from a bank, such as under a line of credit agreement, which permits a firm to borrow instantly up to a specified maximum amount. A company may also find some cash unnecessarily tied up in other accounts, such as advances to employees. Excess cash should be invested in marketable securities for a return.

Note, however, that cash in some bank accounts may not be available for investment. For instance, when a bank lends money to a company, the bank often requires the company to keep funds on hand as collateral. This deposit is called a compensating balance, which in effect represents restricted cash for the company.

Holding marketable securities serves as protection against cash shortages. Companies with seasonal operations may buy marketable securities when they have excess funds and then sell the securities when cash deficits occur.

A firm may also invest in marketable securities when funds are being held temporarily in anticipation of short term capital expansion. In selecting an investment portfolio, consideration should be given to return, default risk, marketability, and maturity date.

The thrust of cash management is to accelerate cash receipts and delay cash payments. Each bank account should be analyzed as to its type, balance, and cost so that corporate return is maximized.