Cash and liquidity management are crucial for businesses to maintain financial stability and seize opportunities. Companies hold cash for transactions, precautions, and speculation, while also utilizing marketable securities as near-cash assets to earn higher returns.

The cash conversion cycle measures the time between cash outflows and inflows, impacting liquidity efficiency. Cash budgeting techniques help forecast and manage cash flows, while short-term investment options like T-bills and commercial paper allow businesses to balance safety, liquidity, and yield for excess funds.

Cash and Liquidity Management

Motives for cash holdings

• Transaction motive
  • Holds cash to cover routine business expenses (payroll, rent, utilities)
  • Ensures smooth day-to-day operations without disruptions
• Precautionary motive
  • Maintains cash reserves as a safety net for unforeseen expenses (equipment breakdowns, lawsuits)
  • Provides financial stability during uncertain times (economic downturns, natural disasters)
• Speculative motive
  • Keeps cash available to capitalize on profitable opportunities (discounted inventory purchases, acquisitions)
  • Allows flexibility to act quickly when favorable investments arise
• Marketable securities serve as near-cash assets
  • Highly liquid short-term investments convertible to cash within a year (Treasury bills, money market funds)
  • Earn higher returns than cash while maintaining liquidity for future needs

Cash conversion cycle impact

• Cash conversion cycle $CCC$ measures time between cash outflows for inventory and cash inflows from sales
  • Formula: $CCC = DIO + DSO - DPO$
  • $DIO$: Days Inventory Outstanding, average time to sell inventory
  • $DSO$: Days Sales Outstanding, average collection period for accounts receivable
  • $DPO$: Days Payable Outstanding, average payment period for accounts payable
• Shorter $CCC$ indicates more efficient liquidity management
  • Faster inventory turnover reduces carrying costs and obsolescence risk
  • Quicker collection of accounts receivable improves cash flow and reduces bad debt
  • Longer payment terms with suppliers allows more time to generate cash from sales
• Longer $CCC$ may strain liquidity and increase financing costs
  • Slow-moving inventory ties up cash and may require markdowns to sell
  • Delayed customer payments create cash flow gaps and may lead to write-offs
  • Shorter payment terms with suppliers require cash outflows before generating sales

Cash budgeting techniques

• Cash budget projects expected cash inflows and outflows over a defined period
  • Identifies potential cash surpluses for investment or cash deficits requiring financing
  • Allows proactive management of liquidity to avoid shortfalls or idle cash
• Steps to create a cash budget:
  1. Estimate expected cash receipts from various sources (sales, investments, loans)
  2. Estimate expected cash disbursements for various purposes (expenses, loan payments, dividends)
  3. Calculate net cash flow by subtracting cash disbursements from cash receipts
  4. Determine ending cash balance by adding net cash flow to beginning cash balance
• Sensitivity analysis tests impact of changes in assumptions on cash budget outcomes
  • Identifies potential risks (lower sales, higher expenses) and opportunities (faster collections, cheaper financing)
  • Prepares contingency plans for various scenarios to ensure adequate liquidity

Short-term investment options

• Criteria for evaluating short-term investments:
  • Safety minimizes risk of default or loss of principal (government-backed securities, insured deposits)
  • Liquidity enables quick conversion to cash without significant loss of value (money market funds)
  • Yield maximizes return on investment while balancing safety and liquidity (commercial paper)
• Treasury bills $T-bills$ are short-term government securities maturing within a year
  • Backed by full faith and credit of the U.S. government, considered risk-free assets
  • Sold at a discount from face value, difference represents interest earned at maturity
• Commercial paper is unsecured short-term debt issued by corporations to fund operations
  • Higher yields than $T-bills$ due to slightly higher default risk of corporations vs. government
  • Typically issued by large, creditworthy companies to minimize risk for investors
• Certificates of deposit $CDs$ are time deposits with fixed maturity dates and interest rates
  • FDIC insurance up to $250,000 per depositor per bank eliminates risk of loss
  • Early withdrawal penalties incentivize holding $CDs$ to maturity to earn stated return
• Money market funds invest in a diversified portfolio of short-term, high-quality debt securities
  • Provides liquidity by allowing investors to withdraw funds on demand
  • Offers higher yields than bank accounts while maintaining stable $1 per share net asset value