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Principles of Finance

19.3 Cash Management

Principles of Finance19.3 Cash Management

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

By the end of this section, you will be able to:

  • Explain why firms hold cash.
  • List instruments available to a financial manager for investing cash balances.

Cash management means efficiently collecting cash from customers and managing cash outflows. To manage cash, the cash budget—a forward-looking document—is an important planning tool. To understand cash management, you must first understand what is meant by cash holdings and the motivations (reasons) for holding cash. A cash budget example is covered in Using Excel to Create the Short-Term Plan.

Cash Holdings

The cash holdings of a company are more than the currency and coins in the cash registers or the treasury vault. Cash includes currency and coins, but usually those amounts are insignificant compared to the cash holdings of checks to be deposited in the company’s bank account and the balances in the company’s checking accounts.

Motivations for Holding Cash

The initial answer to the question of why companies hold cash is pretty obvious: because cash is how we pay the bills—it is the medium of exchange. The transactional motive of holding cash means that checks and electronic funds transfers are necessary to meet the payroll (pay the employees), pay the vendors, satisfy creditors (principal and interest payments on loans), and reward stockholders with dividend payments. Cash for transaction is one reason to hold cash, but there is another reason—one that stems from uncertainty and the precautions you might take to be ready for the unexpected.

Just as you keep cash balances in your checking and savings accounts and even a few dollars in your wallet or purse for unexpected expenditures, cash balances are also necessary for a business to provide for unexpected events. Emergencies might require a company to write a check for repairs, for an unexpected breakdown of equipment, or for hiring temporary workers. This motive of holding cash is called the precautionary motive.

Some companies maintain a certain amount of cash instead of investing it in marketable securities or in upgrades or expansion of operations. This is called the speculative motive. Companies that want to quickly take advantage of unexpected opportunities want to be quick to purchase assets or to acquire a business, and a certain amount of cash or quick access to cash is necessary to jump on an opportunity.

Sometimes cash balances may be required by a bank with which a company conducts significant business. These balances are called compensating balances and are typically a minimum amount to be maintained in the company’s checking account.

For example, Jack’s Outback Restaurant Group borrowed $500,000 from First National Bank and Trust. As part of the loan agreement, First National Bank required Jack’s to keep at least $50,000 in its company checking account as a way of compensating the bank for other corporate services it provides to Jack’s Outback Restaurant Group.

Cash Alternatives

Cash that a company has that is in excess of projected financial needs is often invested in short-term investments, also known as cash equivalents (cash alternatives). The reason for this is that cash does not earn a rate of return; therefore, too much idle cash can affect the profitability of a business.

Table 19.3 shows a list of typical investment vehicles used by corporations to earn interest on excess cash. Financial managers search for opportunities that are safe and highly liquid and that will provide a positive rate of return. Cash alternatives, because of their short-term maturities, have low interest rate risk (the risk that an investment’s value will decrease because of changes in market interest rates). In that way, prudent investment of excess cash follows the risk/return trade-off; in order to achieve safe returns, the returns will be lower than the possible returns achieved with risky investments. Cash alternative investments are not committed to the stock market.

SecurityDescription
US Treasury billsObligations of the US government with maturities of 3 and 6 months
Federal agency securitiesObligations of federal government agencies such as the Federal Home Loan Bank and the Federal National Mortgage Association
Certificates of depositIssued by banks, a type of savings deposit that pays interest
Commercial paperShort-term promissory notes issued by large corporations with maturities ranging from a few days to a maximum of 270 days
Table 19.3 Typical Cash Equivalents

Figure 19.5 shows a note within the 2021 Annual Report (Form 10-K) of Target Corporation. The note discloses the amount of Target’s cash and cash equivalent balances of $8,511,000,000 for January 30, 2021, and $2,577,000,000 for February 1, 2020.

A note describes the Cash and cash equivalents for the Target Corporation in its 2021 10-K Filing. In this filing, Target lists its cash and cash equivalent investments on January 30, 2021 and February 1, 2020.  Target had investments in cash, short-term investments, and receivables from third-party financial institutions for credit and debit card transactions. These were added together for the total cash and cash equivalents.
Figure 19.5 Note from Target Corporation 2021 10-K Filing (source: US Securities and Exchange Commission/EDGAR)

In that note, which is a supplement to the company’s balance sheet, receivables from third-party financial institutions is also considered a cash equivalent. That is because purchases by Target’s customers who use their credit cards (e.g., VISA or MasterCard) create very short-term receivables—amounts that Target is waiting to collect but are very close to a cash sale. So instead of being reported as accounts receivable—a line item on the Target balance sheet that is separate from cash and cash equivalents—these amounts receivable from third-party financial institutions are considered part of the cash and cash equivalents and are a very liquid asst. For example, the amount of $560,000,000 for January 30, 2021, is considered a cash equivalent since the settlement of these accounts will happen in a day or two with cash deposited in Target’s bank accounts. When a retailer sells product and accepts a credit card such as VISA, MasterCard, or American Express, the cash collection happens very soon after the credit card sale—typically within 24 to 72 hours.3

Companies also invest excess funds in marketable securities. These are debt and equity investments such as corporate and government bonds, preferred stock, and common stock of other entities that can be readily sold on a stock or bond exchange. Ford Motor Company has this definition of marketable securities in its 2019 Annual Report (Form 10-K):

“Investments in securities with a maturity date greater than three months at the date of purchase and other securities for which there is more than an insignificant risk of change in value due to interest rate, quoted price, or penalty on withdrawal are classified as Marketable securities.”4

Footnotes

  • 3Creditcardprocessing.com. “How Long Does it Take for a Merchant to Receive Funds?” n.d. https://www.creditcardprocessing.com/resource/article/long-take-merchant-receive-funds/#:~:text=The%20time%20that%20it%20takes,days%20to%20process%20the%20payment
  • 4Ford Motor Company. “2019 Annual Report.” n.d. https://s23.q4cdn.com/725981074/files/doc_downloads/Ford-2019-Printed-Annual-Report.pdf
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