Cash Management

RUNNING HEAD: CASH MANAGEMENT

Cash Management

Introduction

Most companies do not want to keep any more cash on hand than what is absolutely necessary. Most companies must keep some cash for transactions, bank payments, and potential emergencies. The opportunity cost of holding an excess of cash rather than reinvesting it into current assets or growing the firm’s fixed assets is often significant. There are multiple techniques that a firm can employ to manage its cash. Some of these techniques include float, short-term investments, and international cash management. These techniques are discussed in the following sections.

Due to the opportunity cost of holding excess cash, most companies try to leverage the minimal amount of cash that they carry to cover as many payables as possible. One way that firms achieve this goal is by employing the use of float. Float refers to the difference between the balance carried on the corporate books and the amount credited to the corporation by its bank (Block & Hirt, 2005). Payables and receivables are entered into corporate books as processed; however, the actual transactions will not be recorded by the bank until the payment has been received and processed by a company and later processed by the bank. Companies frequently work to take advantage of this opportunity to use their cash up until it is claimed by the recipient’s bank by improving collections and extending disbursements. The more efficiently a firm can collect on its receivables and the more time it can take in paying its own bills, the lower the firm’s cash requirements for payments will be. While some companies take this to the extreme of consistently operating with a negative cash balance in their books, they must be aware of the risk of being caught without cash in unforeseen circumstances or upon the start of a tight money cycle.

While the float stretches cash on hand by delaying payables and increasing speed of receivables, and short-term investments attempt to maximize the cash on hand in various ways, international cash management takes advantage of today’s global economy. Companies may opt to hold cash balances in a particular currency because it has a strong exchange rate in comparison to the company’s home currency. Likewise, a financial manager may seek out a country with high interest rates to apply the company’s cash to short-term investments in those countries. For example, an American company may choose to hold its cash reserves in the Euro or English pound because these currencies and interest rates are stronger than the dollar. Like the float, while this practice may benefit a company, the financial manager should fully assess the risk of international investing, considering such factors as the volatility of a country’s economy and government, along with any ethical concerns that may arise from cultural differences between countries and how they are viewed by potential investors.

While some very aggressive companies carry negative cash balances by utilizing the float, more conservative companies may hold excess funds when anticipating a cash outlay. While these (short-term investments) funds are being held, they should be converted from cash to more profitable interest-earning marketable securities (Block & Hirt, 2005). There is a wide range of securities from which to choose; the financial manager should consider yield, maturity, minimum investment required, safety, and marketability when selecting a security (Block & Hirt, 2005). As a rule, the longer a security’s maturity period, the higher return it will yield. However, as with any cash management decision, there is risk to consider. If interest rates dramatically increase during the security’s maturity period, the company’s cash may be tied up when it has the opportunity to purchase higher-yielding securities resulting from the increased interest rates

In the same way that a company must develop a strategy for managing its cash in short-term investments, the firm must also participate in methods of short-term financing. Short-term financing can be used to offset the cash flow issues that arise from production and demand not constantly aligning. Three types of short-term financing include trade credit, bank loans, and commercial paper. Like the benefits previously discussed for international investing, firms can take advantage of foreign interest rates and exchange rates when borrowing money as well. This is a factor to consider as reviewing each of the following types of short-term financing.

Trade credit is the largest single source of credit, accounting