Chapter 6 - Cash Management: Learning Objectives

Chapter 6 - Cash Management
Learning Objectives
Upon finishing this lecture, you are expected to:
✓ Understand and explain the importance of cash management.
✓ Manage receipts and disbursement including floats, speeding up collections, and slowing down payments.
✓ Compute for cash conversion cycle, its funding requirements, and the key strategies for managing it.
✓ Compute and explain cost of discount forgone.
Introduction and Values Integration

To some people, the term cash management conjures up images of placing cash in a bank for safekeeping. Interestingly
enough, the field of cash management has broadened considerably. Cash concepts and techniques are applied to a wide
range of activities and situations outside the cash parlance alone. As it goes beyond, cash becomes more important than
just merely receiving and placing it in a bank and disbursing it.
Actually there are a lot of good reasons why one has to manage cash well. Aside from the fact that cash is the core of
business operation, being able to manage cash well will help you avoid a lot of financial problems like wrong
investments and credit decisions. And again, as much as we want you to be the best accounting and finance people out
there, want you to first be people of integrity and good character.
How well do you know cash?

Before a person can manage cash, he/she should have a sound knowledge of what cash is all about.
Types of Cash
1. Cash on hand. This represents the remaining cash collection of the day waiting to be deposited the following
banking day.
2. Cash in bank. This represents the cash already deposited in the bank.
3. Cash fund. There are different types of cash fund:
a. Petty cash fund - the funds that will cater to the small expenditures of the company.
b. Change fund - the fund used to maintain loose change to address the concern for small bills and coins.
c. Dividend fund - the fund used to pay for the dividends that the board of directors has declared and payable
a time certain in the future.
Cash Equivalent
Cash equivalents are short-term, highly liquid investments that are readily convertible to cash. These are investments
which are so near their maturity dates, making risks inherent to the investment insignificant. Based on PAS 7,
investments with the original maturity of three months or less is qualified as a cash equivalent. Thus, the purchase must
be three months or less before the maturity date.
Examples of cash equivalent:

• A 90-day treasury bill
• A 180-day treasury bill purchased 90 days before its maturity
• A 90-day time deposit
• Long-term commercial paper purchased within 90 days before its maturity
• Other money market instruments whose maturity is within three months
Advantages of Holding Cash or Cash Equivalents

1. Taking advantage of the trade discounts. Suppliers give discounts to encourage early payments. Thus, payment
within the discount period results in less outflow of cash. However, cost and benefit analysis must be done before
availing of such discount.
2. Maintenance of good credit rating. Having a good current and quick asset ratio on a par with the industry, the firm
will be able to maintain good credit standing with suppliers offering favorable credit terms and with bank giving
low interest rate.
Financial Management Page 1

low interest rate.
3. Favorable business opportunities. Firms may take advantage of special offers from suppliers and a possible
takeover of another firm.
4. Meeting emergencies. Firms may immediately recover losses brought about by fire, typhoons, strikes, and other
unexpected events.
5. Capacity to compete. Having enough cash enables the firm to face its competitors by expanding or developing new
products or advertisements.
Factors Affecting Cash Requirements

1. Firm's policy on cash management. This refers to the amount of cash a firm needs to cover for a certain number of
days of the business operations. It is dependent on how fast cash is generated by the firm.
2. Availability of loans. A firm with good credit standing may hold a cash balance at low levels without putting the
firm at risk. Funds are always available when the need arises.
3. Forecasted cash inflow and outflow. Differences between the inflows and outflows are determined by analyzing
the collections and disbursements records of the firm.
4. Unpredictable events. Firms should not only account for predictable collections and disbursements. They should
also prepare for any unpredictable event holding marketable securities or securing credit lines.
Possible Placements for Excess Cash

1. Savings and/or current accounts. These are bank placements with no holding period.
2. Time deposits. There are placements with holding period.
3. Stocks. These are shares of stocks traded in the formal stock exchange and are bought from stockbrokers.
4. Treasury bills. These are short-term obligations issued by the government.
5. Commercial papers. These are unsecured promissory notes issued by firms with high credit standings.
Controlling Cash Flows

Controlling the cash flow is the main objective of cash management. Through the years, firms and finance partners alike
have been finding ways and means to maximize the use of cash. Maximizing the use of cash means minimizing cash
outflows and maximizing cash inflows.
The following tools may be used for controlling cash flows:

a. Synchronizing cash flow
b. Cash floats on
i. Payments
ii. Collections
c. Extending cash payments
d. Availing of cash discounts
e. Optimum transaction size
Synchronizing Cash Flows

This is the process in which the cash inflows coincide with the outflows. A synchronized cash flow is highly dependent on
an accurate forecast of inflows and outflows. A more accurate forecast helps the firm minimize its cash balance since it
can immediately determine the time when the cash will actually be needed. As a result, there will be less borrowings,
lower interest expense, and maximized profits.
Floats on Disbursements
These are the difference between the company's book balance and bank account balance in any period of time. Float
exists when the firm issues its own check and sends it to the payee company. The payee, in return, has to deposit the
check in their bank account. The number of days form the issuance of the check to its clearance is known as float days.
A float can be classified into three categories:

1. Mail float. It is from the time the check is issued up to the time the check is received by the payee.
2. Processing float. It is from the time the check is received by the payee until the time it is deposited in the payee's
bank account.
3. Clearing float. It is from the date the check is deposited up to the date the check is cleared and made available for

3. Clearing float. It is from the date the check is deposited up to the date the check is cleared and made available for
use.
For the issuer of the check, a float gives a considerable advantage to working capital. On the other hand, the recipient
has to think of ways to reduce the float days.
Reduction of Collection Float

1. Collecting center or agent. Float can be reduced by strategically locating a collection center near the customer.
The collection center can be a firm providing a collection service, or a bank where payments are made directly to
the firm's account.
A firm may also consider the possibility of having its own collecting agents or collecting centers, if it is
economically possible to reduce the collection period in a certain area.
Example:
Cunanan corporation has an agreement with RCBC to collect P3,000,000 a day in exchange for a compensating
balance of P1,000,000. the firm, with a significant increase in its customer in the area, is thinking of cancelling the
agreement and dividing the service provided by RCBC and ABC Bank. With this plan, RCBC will handle the
collection of P2,000,000 with a compensating balance of P800,000. On the other hand, ABC Bank will handle the
other P1,000,000 collection in exchange for a compensating balance of P700,000. With the planned arrangement
with the two banks to perform the collection, the firm is expecting to reduce the collection period by one day. The
firm's rate of return is 9%. Should Cunanan Corporation pursue the division of service between RCBC and ABC
Bank?
Amount of cash collection per day P3,000,000

Number of days freed on the collection x1
Amount of cash freed P3,000,000
Less: Increase in compensating balance 500,000
Increase in cash flow 2,500,000
Rate of return x 0.09
Incremental income P225,000
Based on the analysis above, Cunanan Corporation should pursue the plan of dividing the service between RCBC
and ABC Bank. Despite the increase in compensating balance from P1,000,000 to P1,500,000, the firm will be able
to increase its cash flow by P2,500,000 resulting to an incremental income of P225,000 per year.
2. Lockbox system. It is a system where the company has a P.O. box number address. A lockbox is a bank-operated
mailing address to which a company directs its customers to send their payments. The bank opens the incoming
mail, deposits all received funds in the company's bank account, and scans the payments and any remittance
information. The variables in the analysis are:
a. Cost of the service
b. Number of days in which the float is reduced
c. The amount of check to be converted immediately into cash
d. Expected rate of return of cash freed
To be acceptable, the benefit should be greater than the cost of the lockbox system.
Example:
Cunanan Corporation has average cash receipts of P150,000 per day. Normally, it takes 7 days from the time the
check is received for it to be made available as cash. How much cash is tied up?
Computation shall be as follows:

Computation shall be as follows:
Average cash receipts per day P150,000
Number of days tied up x7
Amount of cash tied up P1,050,000
Another example:
Cunanan Corporation has an average of seven days to receive and deposit the checks from customers. The owner
believes that it takes too long for the firm to use the funds to support its operations. In answer to this problem, a
bank offers its service through the use of a lockbox system. The banker explains that with the system in place, the
expected float time will be reduced to 4 days. The bank charges P10,000 per month for its overhead cost on the
service. Should Cunanan Corporation avail the service offered by the bank? How much is the advantage or
disadvantage of the lockbox system, considering the firm's average daily collection of P450,000 and the annual
rate of return of 12% in the market?
The cost-benefit analysis is as follows:

Average cash receipts per day P450,000
Number of days cash is freed (7 days - 4 days) x3
Amount of cash freed up P1,350,000
Rate of return x 12%
Expected return (benefit) P162,000
Less: cost of the lockbox system (P10,000 x 12) 120,000
Net advantage of availing the lockbox system P42,000
Cost of Foregoing a Cash Discount

Cash discount is categorized under short-term financing. However, for the purpose of discussion, it will be included
under cash management. According to investopedia.com, cash discounts refer to an incentive that a seller offers to a
buyer in return for paying a bill before the scheduled due date.
The credit term is a payment term where credit is granted to a customer. Its benefits include the credit period, the cash
discount offered, and the discount period. For instance, if the term is 2/10, n/30, the customer will get a 2% discount if
the purchase is paid within 10 days, otherwise, the total amount of obligation is due on the 30th day.
Formula of cash discount
When to avail discount?

Before availing of the cash discount, the firm should conduct a cost-benefit analysis first. Thus, if the borrowing rate in
the market is greater than the cost of the discount, then it will be better not to avail of the cash discount. On the other
hand, of the borrowing rate is less than the cost of discount, it will be better for the firm to take advantage of the cash
discount.

discount.
Example:
ABC Company is considering the discount on the credit term offered by the supplier. The terms are 4/10, n/60. At the
time the term is offered, the borrowing rate in the market is 12% per annum. Should ABC Company avail of the discount
offered?
The analysis will be as follows:
Since the cost of borrowing is 12% which is lower than the cost of discount forgone, ABC Company should avail of the
discount. Thus, the firm may borrow from the bank at the rate of 12% and pay the supplier at a discount rate. The net
advantage of the firm from the discount is 18% (30% - 12%).
References:
Fundamentals of Financial Management by Ma. Flordeliza L. Anastacio
Financial Management by Ferdinand L. Timbang, CPA, MBA

Chapter 6 - Cash Management: Learning Objectives

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Chapter 6 - Cash Management

Introduction and Values Integration

How well do you know cash?

Examples of cash equivalent:

Advantages of Holding Cash or Cash Equivalents

Financial Management Page 1

Factors Affecting Cash Requirements

Possible Placements for Excess Cash

Controlling Cash Flows

The following tools may be used for controlling cash flows:

Synchronizing Cash Flows

A float can be classified into three categories:

Financial Management Page 2

Reduction of Collection Float

Amount of cash collection per day P3,000,000

Computation shall be as follows:

Financial Management Page 3

The cost-benefit analysis is as follows:

Cost of Foregoing a Cash Discount

Formula of cash discount

When to avail discount?

Financial Management Page 4

The analysis will be as follows:

Financial Management Page 5

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