Basic Cash Management Workshop

1
Basic Cash Management Workshop

• MSAFP, February 19, 2004
• Jim Washam
• Matthew Hill

2
Measuring Liquidity

• What is Liquidity?
• Determining the Proper Level
• Sources of Liquidity
• Costs of Maintaining Liquidity
• The Cash Conversion Cycle

3
What is Liquidity?

• The ability to quickly convert an asset into cash
  without incurring substantial transactions costs
  or loss in value.
• Transactions costs- brokerage fees, etc.
• Increased liquidity denotes a decrease in risk.

4
Two Applications of Liquidity Analysis

• Asset liquidity- stocks, bonds, commercial paper,
  t-bills, etc.
• In this context, liquidity is a function of the
  assets price stability, disposal costs, and
  secondary market trading status.

5
Two Applications of Liquidity Analysis

• Firm liquidity- measures the firms ability to
  meet its cash obligations financial
  flexibility.
• Increased liquidity increases firm value.
• Creditors are very interested in the debtors
  liquidity levels.

6
Reasons for Liquidity

• Transactions requirement- bill paying
• Precautionary requirement- unpredictability of
  inflows what-if scenarios
• Speculative requirement- investment opportunities

7
A Firms Sources of Liquidity

• Cash flow from operations
• Cash and marketable securities
• Unused short-term borrowing capacity

8
Cost of Excessive Liquidity

• Opportunity costs
• An inverse relationship exists between an
  assets liquidity level and its rate of return.
• Ex. T-bills

9
Costs of Illiquidity????

• Delayed payments
• Cost of lost opportunities
• Additional interest costs
• Transactions costs

10
Determinants of the Proper Liquidity Level

• Variability of cash flows
• The percentage of cash flows that are accounts
  receivable
• Variability of sales
• Typically, the proper liquidity level is
  dependent on the respective industry.

11
Cash Conversion Cycle

• The time it takes to convert cash outflows into
  cash inflows.
• The firm wants to minimize its CCC.

12
Cash Conversion Cycle
Days Inventory
Days Receivables
Purchase of Resources
Cash Conversion Cycle
Days Payable
13
CCC

• CCC (365) (Inv/CGS) (AR/Sales)
  (AP/CGS)
• (Inv/CGS)365 Days Inventory
• (AR/Sales)365 Days Receivables
• (AP/CGS)365 Days Payables
• CCC DI DR - DP

14
CCC Example

• Inventory 2,600
• Accounts Receivable 1,700
• Accounts Payable 1,600
• CGS 9,200
• Sales 15,000
• DI (2,600/9,200)365 103.2 Days
• DR(1,700/15,000)365 41.4 Days
• DP(1,600/9,200)365 63.5 Days
• CCC 103.2 41.4 63.5 81.1 Days

15
(No Transcript)
16
Managing Corporate Cash Flows

• U.S. Payments System
• Measuring Float
• Collection Systems
• Disbursement Systems and Products

17
Major Payment Methods

• Cash
• Checks
• Electronic
• ACH
• Fedwire
• Plastic

Federal Reserve, 2002
18
Understanding Checks

• Funds are not available immediately after
  deposit
• Ledger Balance
• Available Balance
• Collected Balance
• Checks must be delivered to drawee bank for
  collection

19
Understanding Checks

• Clearing Channels
• On-us items
• Local clearing house
• Federal Reserve
• Direct Send

20
Understanding Checks

• Clearing Channels
• On-us items
• Local clearing house
• Federal Reserve
• Direct Send

21
Understanding Checks

• Clearing Channels
• On-us items
• Local clearing house
• Federal Reserve
• Direct Send

22
Understanding Checks

• Clearing Channels
• On-us items
• Local clearing house
• Federal Reserve
• Direct Send

23
Understanding Checks

• Clearing Channels
• On-us items
• Local clearing house
• Federal Reserve
• Direct Send

24
Understanding Checks

• Availability Schedule
• Gives availability of items according to endpoint
  and deposit time

25
Understanding Checks

• Check 21
• Authorizes the use of a new negotiable instrument
  called a substitute check.
• Will go into effect on October 28, 2004.

Federal Reserve
26
Automated Clearing House (ACH)

• Electronic, batch payments system
• Standard settlement 1 day
• May be credit or debit transactions
• Prearranged Payment or Deposit (PPD)
• Corporate Concentration or Disbursement (CCD)
• CCD
• Corporate Trade Exchange (CTX)
• RCK and POP

27
Automated Clearing House (ACH)
Source NACHA
28
Fedwire

• Funds Transfers are Immediate
• Transactions are Irrevocable
• Receiving Institution is Guaranteed Payment by
  the Fed.
• Each Transaction is Handled Separately

29
Fedwire

• Wire Transfer Classifications
• Repetitive
• Dollar Amount May be changed
• Semirepetitive
• Dollar Amount and Description may be changed.
• Nonrepetitive
• May change the debt and credit parties.
• Drawdown Wire
• Debit Wire

30
Fedwire

• Fedwire Transactions
• Must Specify
• Account from which money is being withdrawn
• Amount of Transfer
• Bank account to which the money is being sent
• Optional Reference or Identifying information
• Initiating firm will be given a Fed. Reference
  number by the Originating Bank.

31
Collection System Objectives

• Mobilize funds
• Access daily deposit information
• Update accounts receivable (cash application)
• Support audit trails

32
Collection Systems

• Over-the-Counter / Field Deposit Systems
• Receipts collected at field locations
• Retail payments, including cash, checks, debit
  cards, credit cards.
• Wholesale payments,including procurement cards,
  checks

33
Collection Systems

• Mail
• Payment sent to company or to third party lockbox
• Used for both retail and wholesale payments
• Electronic --ACH or wire transfer
• Repetitive consumer payments
• Repetitive and one-time wholesale payments

34
Collection Float

• The delay between the time the payor mails the
  check and the time the payee receives available
  funds
• Float components
• Mail (1 - 5 days)
• Processing (1 -3 days)
• Availability (0 - 3 days)

35
Measuring Float

• Collection Float is measured in dollar days
• Collection Float dollars x days
• Example

Collection Float Dollars x Days
3,000,000 x 4 days 12,000,000 dollar days
36
Measuring Float

• Average Daily Float
  Total Dollar Days of Float
  Total Calendar Days in
  Period
• Annual Cost of Float
  Average Daily Float x Opportunity Cost

37
Measuring Float
38
Measuring Float

• Average Daily Float
• Annual Cost of Float
• Other Information
• 30 days in month
• Cost of funds is 4.0

77,000,000 / 30 2,566,667
2,566,667 x .04 102,667
39
Lockbox

• A collection method by which a bank or third
  party contracts to receive, process and deposit a
  companys receipts
• Wholesale (manual / semi-automatic) -- high
  dollar / low volume (business payments)
• Retail (automated) -- low dollar / high volume

40
(No Transcript)
41
Types of Lockboxes

• Retail
• Consumer Payments
• High Volume
• Small Dollar Amounts
• Main Concern is Usually Processing Costs
• Automated Process
• Maintenance 161.11
• Per Item 0.19

• Wholesale
• Corporate Payments
• Low Volume
• High Dollar Amounts
• Main Concern Float
• Manual Process
• Maintenance 120.48
• Per Item 0.47

www.phoenixhecht.com
42
Lockbox Studies

• Dollar Amount of Remittances
• Zip Codes of Mailing Locations
• RTN of the Check
• Postmark Dates
• Date of Deposit
• Customer Name

43
Lockbox Cost/Benefit

• Calculate the annual float savings gained through
  implementation
• Calculate cost of float without and with lockbox
• Subtract associated costs with lockbox for a net
  savings
• Maintenance
• Per item charges

44
Electronic Collection Systems

• ACH Collection
• Advantages?
• Disadvantages?
• Fedwire
• Advantages?
• Disadvantages?

45
Cash Concentration

• Companies Collect Cash
• May be Deposited in Several Different Locations
• Companies Will Move Cash into a Central Account
• Concentration (Master) Account

46
Concentration System Design

• Over-the-Counter Collection Systems
• Many Collection Points
• Multiple, Small Deposit Banks
• Deposit Availability
• Lockbox Systems
• Few Collection Points
• Large Regional or National Banks
• Deposit Availability

47
Concentration Cost Components

• Excess Bank Balances
• Average Collected Balance Exceeds the Required
  Compensating Balance or Target Balance
• Causes of Excess Balances
• Deposit Reporting Delays
• Clearing Delays
• Transfer Initiation Delays

48
Concentration Cost Components

• Transfer Charges
• Bank Fees
• Third Party Vendor Charges
• Administrative Costs
• Managing Deposit Reporting
• Scheduling Cash Transfers
• Overdrafts
• Missed Deposit Deadlines

49
Disbursement System Objectives

• Cost Reduction
• Opportunity Costs
• Bank Fees
• Float Management
• Access to Information
• Fraud Prevention
• Vendor Relationships

50
Zero Balance Accounts (ZBA)

• Disbursement Account in which the Balance is
  maintained at 0
• End of Day Funding from Master Account
• Credits Debits Netted at End of Each Day

51
Controlled Disbursement

• Early Morning Reporting on Checks to be Presented
  for Payment Later in the Day Against the
  Disbursement Account
• Notification Early or Midmorning (800-1000)
• May Have 2 Notifications

52
Preventing Check Fraud

• Ordinary Care
• Reasonable Commercial Standards
• Bank Statements Must Be Reconciled within a
  Reasonable Time. (UCC 4)
• Full Reconciliation
• Positive Pay
• Electronic Payments

53
Positive Pay

• Company Sends File of Written Checks to Bank
• Bank Compares Presented Checks to Disbursement
  File
• Reverse Positive Pay

54
Short-Term Investing

• Objectives
• Treasury Yield Curve
• Investment Instruments
• Measuring Investment Returns

55
Why Hold Short-Term Investments

• Liquidity Provision
• Temporary Surplus Funds
• Positive Net Cash Flow
• Seasonality
• Asset Sales
• Timing of Securities Issuance
• Income Generation

56
Investment Objectives Policy

• Preservation of Principal
• Liquidity Management
• Balancing Risk and Return
• Maximize return within acceptable risk parameters

• Purpose (Objective)
• Maturity and Segmentation
• The portfolio may serve more than one purpose
• Company Tax Status
• Munis?
• Staffing
• Investment Restrictions
• Reporting Requirements

57
Understanding the Yield Curve
58
Interest Rate Sensitivity

• Inverse relationship between interest rates and
  bond prices

Interest Rates
Interest Rates
Bond Prices
Bond Prices

• Duration measures the sensitivity of bond prices
  to changes in interest rates.

59
U.S. Treasury Securities

• Treasury Bills
• money market
• discount instrument
• minimum 1,000
• Treasury Notes
• 2, 5, 7 10 years
• Semi-annual coupon
• Treasury Bonds
• 30 years
• Semi-annual coupon

• Issued by Auction
• Registered and Book Entry
• Liquidity
• Full Faith Credit
• Interest Exempt from State Income Tax
• Benchmark Yields

60
Repurchase Agreements

• Collateralized Transaction between a Securities
  Dealer and Investor
• Interest Calculated on a 360-day Basis
• Maturities Overnight to Over 1 Year

61
Agency Securities

• FNMA (GSE)
• Freddie Mac (GSE)
• FHLB (GSE)
• GNMA (FFC)
• Vinne Mac (FFC)
• Fed. Farm Credit Banks
• Insured by Farm Credit Insurance Corp.
• Farmer Mac
• Sallie Mae (GSE)

• Good Liquidity
• Low Credit Risk
• State Tax Exemptions

62
Commercial Paper

• Discount instrument issued by corporations
• Maximum Maturity 270 days
• Credit Enhancement
• Backup Line of Credit

63
Municipal Obligations

• Bonds vs. Notes
• Bonds Longer maturities
• Notes Maturities of 2 years or less
• Types of Munis
• General Obligation
• Revenue Securities

64
Pricing T-Bills Commercial Paper

• Both are Money Market Discount Instruments
• Price Quote is the Discount from Face Value
• Price Face Value - Discount
• Discount (Face Value)x(DR)x(n/360)

65
Pricing T-Bills Commercial Paper

• Face Value 10,000
• Discount Rate 0.90
• Maturity 127 days

66
Calculating Yields

• Money Market Yield (MMY)
• Bond Equivalent Yield (BEY)

67
Calculating Yields

• Face Value 10,000
• Discount Rate 0.90
• Maturity 127 days

68
Short-Term Borrowing

• Factors that Determine the Cost of Borrowing
• Short-Term Debt Instruments
• Effective Cost of Borrowing

69
Raising Funds

• There are two primary ways in which firms raise
  funds
• Equity issuance
• Debt issuance

70
Debt Classifications

• Debt can be either long-term, or short-term.
• L-T debt bonds
• S-T debt commercial paper and bank loans
• Cash managers are primarily concerned with s-t
  debt.

71
Cost of Borrowing

• The following factors determine the cost of
  borrowing
• Prevailing interest rates
• Credit risk
• Credit support
• Borrowing horizon

72
Prevailing Interest Rates

• The cost of borrowing (credit) is expressed in
  terms of an interest rate.
• An interest rate can be decomposed into a base
  rate plus a spread.
• Typical base rates are LIBOR (international)
  and Prime.

73
Credit Risk

• A firms probability of defaulting on a given
  loan.
• Who determines credit risk?
• Credit rating agencies (Moodys and Standard and
  Poors)

74
Credit Risk

• Specifically, credit rating agencies assess the
  following
• current earnings
• leverage
• future prospects
• collateral
• The greater a firms credit risk, the greater
  its cost of borrowing.

75
Credit Support

• Credit support is obtained when a third party
  with a higher credit rating than the borrower
  guarantees the debt obligations of the borrower.
  Essentially, the borrower assumes the guarantors
  credit rating.
• Why would a firm counteract as a guarantor?
• A borrowing firm can reduce the cost of its
  debt by seeking credit support.

76
Borrowing Horizon

• Simply the length of the debt instrument.
• The longer the borrowing horizon, the greater
  the cost of borrowing.

77
Short-Term Debt Instruments

• Examples of s-t borrowing instruments are
• Credit lines
• Commercial paper

78
Credit Lines

• An agreement in which the lender gives the
  borrower access to funds up to a maximum amount
  over a specific period of time.
• In terms of personal finance, what does a credit
  line seem like?
• Example characteristics
• Commitment
• Revolving
• Security
• Cleanup period

79
Commercial Paper

• Unsecured, company issued debt with a maximum
  maturity of 270 days.
• Why might the maximum maturity be 270 days?
• Characteristics
• Discount issuance
• Distribution
• Credit enhancement
• Credit rating

80
Basic Cash Management Workshop

• MSAFP, February 19, 2004
• Jim Washam
• Matthew Hill