SHORT-TERM
FINANCIAL MANAGEMENT
Chapter 3 – Cash Holdings
Prepared by Patricia R. Robertson
Kennesaw State University
2
Chapter 3 Agenda
CASH HOLDINGS
Identify the benefits and costs
associated with corporate cash holdings,
discuss motives for holding cash, assess
corporate liquidity using financial ratios,
and explain and use cash management
models.
Cash Flow Timeline
3
The cash
conversion
period is the
time between
when cash is
received versus
paid.
The shorter the
cash conversion
period, the
more efficient
the firm’s
working capital
and more cash
is generated.

The firm is a system of cash flows.

These cash flows are unsynchronized and uncertain.
Cash Holdings
4




The CCP is the length of time to convert cash
disbursements into cash receipts.
It is useful in assessing firm liquidity during ordinary
operations.
It is not a good indicator of a firm’s ability to
withstand cash flow shocks from unexpected events
(e.g.: losing a major customer, litigation, etc.).
This chapter focuses on the role of cash.
Cash Holdings
5


Cash is viewed as an idle corporate resource since it
is a very low yielding asset.
It can include cash in bank accounts and low-risk,
short-term marketable securities.
 The

latter has transaction costs.
Firm’s establish a policy on it’s target cash position
given:
 The
current economic environment.
 Other liquidity sources.
 Upcoming obligations.
Liquidity Strategies
6

To determine the target cash position ($ or % of assets):
 Low-Liquidity
Strategy
 Minimal
cash level (higher risk; higher return).
 Appropriate for firms with predictable cash flows and spare
debt capacity.
 Moderate-Liquidity
Strategy
 More
cash (less risk; less return).
 Strategy matches cash needs to upcoming obligations.
 High-Liquidity
 Large
Strategy
cash-to-asset ratio (low risk; low return).
 Appropriate for firms with high business risk.
Costs and Benefits of Holding Cash
7

The cost of holding cash is the firm’s opportunity cost.

Managers hold cash for the following 3 reasons:
 Transaction
 Cash
is available to run the business without having to
liquidate investments and pay transaction costs.
 Precautionary
 Cash
is available for uncertainties and cash flow shortfalls.
 Speculative
 Cash
is available to capture unexpected opportunities (e.g.:
acquisitions).
Cash-Based Liquidity Measures
8

Liquidity includes both flow and stock.


If cash from operations (flow) is insufficient to cover maturing
obligations, the firm needs access to other resources (stock).
Financial measures to gauge firm liquidity from a cash
perspective are:
Cash Conversion Efficiency
 Cash Ratio
 Cash Burn Rate
 Net Liquid Balance (NLB)
 Current Liquidity Index
 Lambda

Cash Conversion Efficiency (CCE)
9

CCE measures the firm’s ability to convert revenues
into operating cash flows.
 The
CCE should be positive indicating the firm is
successfully converting revenues (sales) to cash flows.
Cash Ratio
10

The cash ratio is the proportion of total assets held
on the balance sheet in cash.
Cash Burn Rate
11

The cash burn rate is the number of days a firm’s
existing cash will last to cover ongoing expenses
without any new cash inflows or external financing.
 The
denominator is dependent on the industry; a service
firm might use operating expenses instead.
WCR & NLB (from Chapter 2)
12
Working Capital Requirements (WCR)
Net Working Capital
Current Assets
Minus
Current Liabilities
Current Assets
Minus
Current Liabilities
Cash
Accounts Payable
Cash
Accounts Payable
Marketable Securities
Notes Payable
Marketable Securities
Notes Payable
Accounts Receivable
CMLTD
Accounts Receivable
CMLTD
Inventory
Accruals and Other
Inventory
Accruals and Other
Prepaids and Other
Prepaids and Other
Net Liquid Balance (NLB)
Current Assets
NWC = WCR + NLB
Minus
Current Liabilities
Cash
Accounts Payable
Marketable Securities
Notes Payable
Accounts Receivable
CMLTD
Inventory
Accruals and Other
Prepaids and Other
Net Liquid Balance (NLB)
13

Net Working Capital = WCR + NLB

NLB = Financial CA – Financial CL
 It
shows ability of stock resources to pay ‘arranged’ maturing
debt which is unaffected by the operating cycle.
 A negative NLB indicates dependence on outside financing.
 Continued sales growth and the permanent increase in WCR
should be financed with a permanent source of financing.
 Seasonal sales growth results in temporary increases in WCR
(A/R and Inventory), which can be financed by drawing down
NLB.
Current Liquidity Index & Lambda
14

These two measures have a coverage component similar to
the Current Ratio, but they also have a time (or flow)
dimension as a result of including a measure of cash flow.
Current Liquidity Index (CLI)
15

CLI combines beginning cash & cash equivalents (‘stock’)
plus expected OCF (‘flow’) in the numerator and
liabilities due in the upcoming year (N/P and CMLTD) in
the denominator.

It indicates if internal liquidity is sufficient to cover maturing
obligations and/or if external financing will be required.

The variability of operating cash flow affects the target
cash level and the need for access to bank credit lines.
Lambda (λ)
16

Lambda accounts for the uncertainty of future cash inflows along
with access to bank lines of credit.
 Lambda measures the probability of illiquidity.
 The numerator represents overall liquidity, including cash,
unused credit lines, and next period’s expected OCF.
 The denominator is cash flow uncertainty, measured as the
standard deviation of operating cash flow.
Lambda includes information about the volatility of expected cash flows.
Historical data is used to calculate the denominator, using the standard deviation
of the distribution of the firm’s expected net cash flow from operations.
λ And Related
Values
17
For
example, a
Lambda of
1.645
signals a
5% chance
of running
out of
cash.
The
approach is
useful in
differentiat
ing
liquidity
risk for
firms with
identical
cash levels.
How Much Liquidity Is Enough?
18

Using Lambda, and based on a firm’s unique circumstances,
a firm need only maintain liquid reserves to meet
unforeseen circumstances arising from a high degree of
uncertainly regarding future cash flows.

If the future is stable, there is a lesser need for liquid resources.
Financial Flexibility
19


Financial Flexibility is related to a firm’s overall
financial structure and if its financial policies allow it
flexibility to take advantage of unforeseen
opportunities.
A flexible short-term financial policy would maintain a
high level of current assets relative to sales, such as:

Maintaining large cash balances.

Maintaining large inventory levels.

Offering liberal credit terms, leading to more sales and a
higher receivable book.
Cash Management Models
20


Firm liquidity includes cash and near-cash investments
(marketable securities).
Holding cash has an opportunity cost; converting securities to
cash involves transaction costs.


Transaction costs include brokerage commissions, funds transfer
fees, costs of communicating instructions and record keeping, etc.)
Firms want to maximize investment returns by minimizing idle
cash while minimizing transactions costs.

Cash management (optimization) models help the firm determine
the optimal number of liquidations per period (and the amount
per liquidation) to minimize total costs.
Cash Management Models
21

We’ll look at three models, each which include
different assumptions:
 Baumol
 Miller-Orr
 Stone
Baumol Model
22

The goal of the Baumol model is to choose the Z*
that results in the optimal trade-off between the
cost of transferring funds out of securities
(transaction costs) and foregone interest from
holding cash (opportunity cost).
Baumol Model Illustrated
23
Baumol Model
24
The Baumol Model assumes:
 The firm has forecasted
cash needs over the
planning period (total cash
need - TCN).
 Cash is replenished by
liquidating investments.
 The firm liquidates
investments periodically, but
must disburse funds at a
continuous, steady rate.
 The firm is able to forecast
cash disbursements with
certainty.
Z
Z/2
The model assumes net cash flow is negative.
When cash reaches zero (or a minimum
“safety” amount), cash is replenished in
consistent increments by selling securities.
THE “OPTIMAL RETURN POINT” TO REPLENISH
CASH IS DENOTED Z* IN THE MODEL.
Baumol Model
25

The Total Cost of the cash position is given by the
following formula:
Transaction Costs
+ Opportunity Cost
Cost/Transaction х Number of Transactions
Period Interest Rate х Average Cash Balance
= Total Cost
Where:
Z* = Cash transfer amount (cash starting and
return point)
F = Fixed transaction cost per sale of security
TCN = Total cash needed during planning period
#
Transactions
Avg. Cash
Balance
i = Interest rate, per period (opportunity cost of
holding cash)
Baumol Model
26
 There
exists some Z* that minimizes the total costs.
 The
first expression includes Z in the denominator; with larger
(but fewer) transactions, Transaction Costs are lower.
 The
second expression includes Z in the numerator; with larger
(less frequent) transactions, Opportunity Cost is higher.
Where:
Z* = Cash transfer amount (cash starting and return point)
F = Fixed transaction cost per sale of security
TCN = Total cash needed during planning period
i = Interest rate, per period (opportunity cost of holding cash)
Baumol Model
27

The goal is to choose the Z* (the Optimal Return Point) that
results in the optimal trade-off between Transaction and
Opportunity Costs.

Z* is the amount of securities that should be sold to replenish cash
when the disbursements account has been drawn down.

Take the derivative of the total cost equation and set equal to zero.
Where:
Z* = Cash transfer amount (cash starting and
return point)
F = Fixed transaction cost per sale of security
TCN = Total cash needed during planning period
i = Interest rate, per period (opportunity cost of
holding cash)
Minimize Total Cost Function
28
1
TCCash  F (TCN ) Z 1  i  Z
2
dTC
1
  F (TCN ) Z  2  i  0
dZ
2
 F (TCN ) Z
Z 2
2
1
 i
2
1
 i
2

 F (TCN )
Z2 
2 F (TCN )
i
Baumol Model Example
29

Using Baumol, determine
Z* given:

Transaction costs (F) are
$65/each.

Annual cash disbursements
(TCN) are $1 million.

Target cash position is $0
(no safety cash).

Short-term securities (i) are
paying 3%/yr.
Where:
Z* = Cash transfer amount (cash starting and
return point)
F = Fixed transaction cost per sale of security
TCN = Total cash needed during planning period
i = Interest rate, per period (opportunity cost of
holding cash)
Baumol Model Example
30

When investments are
liquidated, it is done in
$65,828 increments.

$65,828

$32,914
If disbursements are made
at “a continuous and steady
rate,” the average cash
position is half of $65,828,
or $32,914.
# of Annual Transactions
(TCN/Z)

$1M / $65,828 = 15.19 X
or about every 24 days
Miller-Orr Model
31


Like Baumol, Miller-Orr minimizes total costs (transaction and
opportunity).
Baumol assumed net cash flows are steady and predictable;
Miller-Orr assumes net cash flows are random and
unpredictable.


The model includes two ‘trigger’ points:



Miller-Orr allows for imperfections in daily cash balance forecasts.
Upper Control Limit (UCL) – Triggers a purchase to return cash
balance to the “return point.”
Lower Control Limit (LCL) – Triggers a sale to return cash balance
to the “return point”.
No transactions are made so long as the cash balance
remains within the control limits (ranges).
Miller-Orr Model Illustrative
32
The model allows
for an increase in
the daily cash
position, in addition
to a decreases.
No action occurs so
long as the daily
cash balance
remains within the
range set by the
control limits.
UCL - Purchase
Return Point
If the cash balance
reaches the UCL, cash is
invested to bring cash
levels back to the Return
Point (Z* + LCL). If the
cash balance reaches the
LCL, investments are sold
to bring cash levels back
to the Return Point.
LCL - Sell
Miller-Orr Model Illustrative
So long as the cash balance remains
within the range, no action is taken.
33
UCL – If there is too much cash,
securities are bought returning
the cash balance to the Return
Point (Z* + LCL).
Return Point
LCL – If there is too little cash,
securities are sold returning the
cash balance to the Return Point.
Miller-Orr Model Illustrative
34
Three values must be set:
1) UCL
2) LCL
3) Return Point (Z* + LCL)
Return Point
Miller-Orr Model Formula
35
Miller-Orr Model Example
36

A firm is considering cash variability in its planning
based on the following assumptions:
 Variance
of daily cash flows = $1.0M
 LCL = $0 (could be > $0)
 Transaction Fee = $65/ea.
 Investment Rate = 3%

Calculate Z*:
Miller-Orr Model Example
37


When cash is outside of
the control limits, the firm
takes action to return the
cash balance to the
Return Point, investing
only when cash reaches
the UCL and liquidating
investments at the LCL.
WE NOW HAVE TO
ESTABLISH THE RETURN
POINT, UCL AND LCL.
Miller-Orr Model Example
38

If the LCL is $0 and Z* is $8,402:
 Return
Point
= Z* + LCL
$25,206
= $8,402 + $0 = $8,402
 UCL
= 3Z* + LCL
Return Point
$8,402
= (3 x $8,402) + $0 = $25,206
 Average
Cash Balance
= (4/3)(Z*) + LCL
= (4/3)($8,402) + $0 = $11,203
$0
Miller-Orr Model Example
39




The firm starts with
$8,402 in cash.
If UCL is reached, the
firm invests $16,804.
If the LCL is reached,
the firm sells $8,402 in
investments.
In either case, the firm
returns to the Return
Point (Z* + LCL).
$25,206
INVEST
$25,206 - $8,402 = $16,804
Return Point
$8,402
SELL
$8,402
$0
Miller-Orr Model Example
40

If the LCL is $5,000 and Z* is $8,402:
 Return
Point
= Z* + LCL
$30,206
= $8,402 + $5,000 = $13,402
 UCL
Return Point
= 3Z* + LCL
$13,402
= (3 x $8,402) + $5,000 = $30,206
 Average
Cash Balance
= (4/3)(Z*) + LCL
= (4/3)($8,402) + $5,000 = $16,203
$5,000
Miller-Orr Model Example
41




The firm starts with
$13,402 in cash.
If UCL is reached, the
firm STILL invests
$16,804.
If the LCL is reached,
the firm sells $8,402 in
investments.
In either case, the firm
returns to the Return
Point (Z* + LCL).
$30,206
INVEST
$30,206 - $13,402 = $16,804
Return Point
$13,402
SELL
$8,402
$5,000
Stone Model Example
42

A firm is planning its cash
management activities using Stone; it
begins with the rules for Miller-Orr:
Assume LCL set at $50,000 (cash buffer)
 Assume Z* is calculated at $25,000
Return Point
 Therefore, the control limits are:
$125,000

$75,000
LCL = $50,000
 UCL = 3Z* + LCL



= (3 x $25,000) + $50,000 = $125,000
Return Point = Z* + LCL

= $25,000 + $50,000 = $75,000
$50,000
Stone Model Example
43

A firm is planning its cash
management activities
using Stone; it begins with
the rules for Miller-Orr:
INVEST
The firm starts with
$125,000 - $75,000 = $50,000
$75,000 in cash.
Return Point
 If UCL is reached, the firm
invests $50,000.
 If the LCL is reached, the
SELL
firm sells $25,000 in
$25,000
investments.
 In either case, the firm
returns to the Return Point.
$125,000

$75,000
$50,000
Stone Model Example
44

Now, the Stone model
attributes are added:
The firm selects a ‘lookahead’ period between 3
and 12 days to project the
cash balances; say 7 days.
 It estimates daily, net cash
flows for the look-ahead
period.


It assigns a forecasting error
for the cash flow estimates;
say 3%.
Cash Flow Projections:
Stone Model Example
45


To account for the firm’s estimated
forecasting error, the Miller-Orr
control limits are adjusted by 3%,
shrinking the range.
$125,000
Modified UCL
Return Point
$121,250
$75,000
Modified Control Limits (3% Adjustment)


UCL ($125,000 x 97% = $121,250)
LCL ($50,000 x 103% = $51,500)
Modified LCL
$51,500
$50,000
Stone Model Example
46

All Stone Model assumptions
are assembled:

Control Limits








UCL ($125,000)
Modified UCL ($121,250)
LCL ($50,000)
Modified LCL ($51,500)
Return Point ($75,000)
Look-Ahead Forecast (7 days)
k (3 days)
Cash Flow Projections 

Forecasting Error (3%)
Cash Flow Projections:
Stone Model Example
47



A chart is built for the
length of the look-ahead
period, including Day 0.
The daily, net cash flow
projections are added.
With the beginning cash
balance (say, $105,000),
the estimated daily “Cash
Balance” is calculated
AND the estimated “Cash
Balance in 3 Days” (k) is
calculated, all for the 7
day look-ahead period.
Cash Flow Projections:
Stone Model Example
48


Each day (for the entire
look-ahead) period, the
“Cash Balance” is
compared to original
control limits AND the
“Cash Balance in 3 (k)
Days” is compared to the
modified control limits.
Decision-making is based
on both.
Cash Flow Projections:
Stone Model Example
49
Day 0 - The $105,000 Cash
Balance is below the
$125,000 UCL, so no
further analysis is needed
and no action is taken.
Cash Flow Projections:
Control Limits
 UCL ($125,000); Mod. UCL ($121,250)
 LCL ($50,000); Mod. LCL ($51,500)
Stone Model Example
50
Day 1 - The $150,000
projected Cash Balance is
more than the UCL and it
remains that way for at
least 3 days since,
$160,000, the projected
Cash Balance in 3 Days, is
also more than the
Modified UCL  Plan to
buy $85,000 in securities
on Day 1 bringing cash to
“return point” of $75,000
in 3 days.
•
$160,000 - $85,000 = $75,000
Cash Flow Projections:
Control Limits
 UCL ($125,000); Mod. UCL ($121,250)
 LCL ($50,000); Mod. LCL ($51,500)
Stone Model Example
51
Day 1 - The $150,000
projected Cash Balance is
more than the UCL and it
remains that way for at
least 3 days since,
$160,000, the projected
Cash Balance in 3 Days, is
also more than the
Modified UCL  Plan to
buy $85,000 in securities
on Day 1 bringing cash to
“return point” of $75,000
in 3 days.
•
$160,000 - $85,000 = $75,000
Cash Flow Projections:
Note: If, on Day 1 the Cash Balance changes…
since the ACTUAL Day 1 cash flows were different
than projected...no action has to be taken. It is a
planning tool and the decision rules are flexible.
Stone Model Illustrative
52
Return Point
Stone Model Options
53

A more complex version of Stone calls for the use of
two look-ahead periods.
 For
example, a firm could use both a 2-day lookahead and a 3-day look-ahead.
 Transfers
between cash and securities only take place if
the cash position gets very high or low and is expected
to stay that way for another 2 days (in the first
analysis) and 3 days (in the second analysis).
Cash Trends
54