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SUMMARY INCOME STATEMENT
(all figures except unit sales in thousands of dollars)
Year: 2004 2005 2006
Quarter: 4 1 2 3 4 1
1. Number of cars sold 250 200 200 225 250 275
2. Unit price 20 20 20 20 20 20
3. Unit cost 18 18 18 18 18 18
Revenues (1 — 2)
4. 5,000 4,000 4,000 4,500 5,000 5,500
Cost of goods sold (1 — 3)
5. 4,500 3,600 3,600 4,050 4,500 4,950
6. Wages and other costs 200 150 150 150 150 150
7. Depreciation 80 80 80 80 80 80
8. EBIT (4 “ 5 “ 6 “ 7) 220 170 170 220 270 320
9. Net interest 4 0 76 153 161 178
10. Pretax profit (8 “ 9) 216 170 94 67 109 142
Tax (.35 — 10)
11. 76 60 33 23 38 50
12. Net profit (10 “ 11) 140 110 61 44 71 92



SUMMARY BALANCE SHEETS
(figures in thousands of dollars)
End of 3rd Quarter End of 1st Quarter
2004 2005
Cash 10 10
Receivables 0 10,500
Inventory 4,500 5,400
Total current assets 4,510 15,910
Fixed assets, net 1,760 1,280
Total assets 6,270 17,190

Bank loan 230 9,731
Payables 4,500 5,400
Total current liabilities 4,730 15,131
Shareholders™ equity 1,540 2,059
Total liabilities 6,270 17,190
CASH AND INVENTORY
MANAGEMENT
Cash Collection, Disbursement, and Float
Float
Valuing Float

Managing Float
Speeding Up Collections
Controlling Disbursements
Electronic Funds Transfer

Inventories and Cash Balances
Managing Inventories
Managing Inventories of Cash
Uncertain Cash Flows
Cash Management in the Largest Corporations
Investing Idle Cash: The Money Market

Summary




Not the right way to manage cash.
Why hoard cash when you could invest it and earn interest? Still, you need some cash to pay
bills. What™s the right cash inventory? We will see that managing an inventory of cash is similar
to managing an inventory of raw materials or finished goods.
Telegraph Colour Library/FPG International




201
n late 1999 citizens and corporations in the United States held nearly


I $1,100 billion in cash. This included about $500 billion of currency with
the balance held in demand deposits (checking accounts) with commer-
cial banks. Cash pays no interest. Why, then, do sensible people hold it? Why,
for example, don™t you take all your cash and invest it in interest-bearing securities? The
answer is that cash gives you more liquidity than securities. By this we mean that you
can use it to buy things. It is hard enough getting New York cab drivers to give you
change for a $20 bill, but try asking them to split a Treasury bill.
Of course, rational investors will not hold an asset like cash unless it provides the
same benefit on the margin as other assets such as Treasury bills. The benefit from
holding Treasury bills is the interest that you receive; the benefit from holding cash is
that it gives you a convenient store of liquidity. When you have only a small proportion
of your assets in cash, a little extra liquidity can be extremely useful; when you have a
substantial holding, any additional liquidity is not worth much. Therefore, as a finan-
cial manager you want to hold cash balances up to the point where the value of any ad-
ditional liquidity is equal to the value of the interest forgone.
Cash is simply a raw material that companies need to carry on production. As we will
explain later, the financial manager™s decision to stock up on cash is in many ways sim-
ilar to the production manager™s decision to stock up on inventories of raw materials.
We will therefore look at the general problem of managing inventories and then show
how this helps us to understand how much cash you should hold.
But first you need to learn about the mechanics of cash collection and disbursement.
This may seem a rather humdrum topic but you will find that it involves some interest-
ing and important decisions.
After studying this material you should be able to
Measure float and explain why it arises and how it can be controlled.
Calculate the value of changes in float.
Understand the costs and benefits of holding inventories.
Cite the costs and benefits of holding cash.
Explain why an understanding of inventory management can be useful for cash man-
agement.




Cash Collection, Disbursement,
and Float
Companies don™t keep their cash in a little tin box; they keep it in a bank deposit. To un-
derstand how they can make best use of that deposit, you need to understand what hap-
pens when companies withdraw money from their account or pay money into it.

202
Cash and Inventory Management 203


FLOAT
Suppose that the United Carbon Company has $1 million in a demand deposit (check-
ing account) with its bank. It now pays one of its suppliers by writing and mailing a
check for $200,000. The company™s records are immediately adjusted to show a cash
balance of $800,000. Thus the company is said to have a ledger balance of $800,000.
But the company™s bank won™t learn anything about this check until it has been re-
ceived by the supplier, deposited at the supplier™s bank, and finally presented to United
Carbon™s bank for payment. During this time United Carbon™s bank continues to show
in its ledger that the company has a balance of $1 million.
While the check is clearing, the company obtains the benefit of an extra $200,000 in
the bank. This sum is often called disbursement float, or payment float.
PAYMENT FLOAT
Checks written by a
company that have not yet
cleared. Company™s ledger balance Payment float
$800,000 $200,000


equals


Bank™s ledger balance
$1,000,000



Float sounds like a marvelous invention; every time you spend money, it takes the
bank a few days to catch on. Unfortunately it can also work in reverse. Suppose that in
addition to paying its supplier, United Carbon receives a check for $120,000 from a cus-
tomer. It first processes the check and then deposits it in the bank. At this point both the
company and the bank increase the ledger balance by $120,000:



Company™s ledger balance Payment float
$920,000 $200,000


equals


Bank™s ledger balance
$1,120,000




But this money isn™t available to the company immediately. The bank doesn™t actu-
ally have the money in hand until it has sent the check to the customer™s bank and re-
ceived payment. Since the bank has to wait, it makes United Carbon wait too”usually
AVAILABILITY FLOAT
Checks already deposited 1 or 2 business days. In the meantime, the bank will show that United Carbon still has
that have not yet been an available balance of only $1 million. The extra $120,000 has been deposited but is
cleared. not yet available. It is therefore known as availability float.
Notice that the company gains as a result of the payment float and loses as a result
Difference of availability float. The net float available to the firm is the difference between pay-
NET FLOAT
between payment float and ment and availability float:
availability float.
Net float = payment float “ availability float
204 SECTION TWO




Company™s ledger balance Payment float
$920,000 $200,000


equals


Bank™s ledger balance
$1,120,000


equals


Available balance Availability float
$1,000,000 $120,000




In our example, the net float is $80,000. The company™s available balance is $80,000
greater than the balance shown in its ledger.


Your bank account currently shows a balance of $940. You now deposit $100 into the
Self-Test 1
account and write a check for $40.
a. What is the ledger balance in your account?
b. What is the availability float?
c. What is payment float?
d. What is the bank™s ledger balance?
e. Show that your ledger balance plus payment float equals the bank™s ledger balance,
which in turn equals the available balance plus availability float.



VALUING FLOAT
Float results from the delay between your writing a check and the reduction in your
bank balance. The amount of float will therefore depend on the size of the check and
the delay in collection.


Float
EXAMPLE 1
Suppose that your firm writes checks worth $6,000 per day. It may take 3 days to mail
these checks to your suppliers, who then take a day to process the checks and deposit
them with their bank. Finally, it may be a further 3 days before the supplier™s bank sends
the check to your bank, which then debits your account. The total delay is 7 days and
the payment float is 7 — $6,000 = $42,000. On average, the available balance at the bank
will be $42,000 more than is shown in your firm™s ledger.
Cash and Inventory Management 205


As financial manager your concern is with the available balance, not with the com-
pany™s ledger balance. If you know that it is going to be a week before some of your
checks are presented for payment, you may be able to get by on a smaller cash balance.
The smaller you can keep your cash balance, the more funds you can hold in interest-
earning accounts or securities. This game is often called playing the float.
You can increase your available cash balance by increasing your net float. This
means that you want to ensure that checks received from customers are cleared rapidly
and those paid to suppliers are cleared slowly. Perhaps this may sound like rather small
change, but think what it can mean to a company like Ford. Ford™s daily sales average
over $400 million. If it could speed up collections by 1 day, and the interest rate is .02
percent per day (about 7.3 percent per year), it would increase earnings by .0002 — $400
million = $80,000 per day.
What would be the present value to Ford if it could permanently reduce its collec-
tion period by 1 day? That extra interest income would then be a perpetuity, and the
present value of the income would be $50,000/.0002 = $250 million, exactly equal to
the reduction in float.
Why should this be? Think about the company™s cash-flow stream. It receives $250
million a day. At any time, suppose that 4 days™ worth of payments are deposited and
“in the pipeline.” When it speeds up the collection period by a day, the pipeline will
shrink to 3 days™ worth of payments. At that point, Ford receives an extra $250 million
cash flow: it receives the “usual” payment of $250 million, and it also receives the $250
million for which it ordinarily would have had to wait an extra day. From that day for-
ward, it continues to receive $250 million a day, exactly as before. So the net effect of
reducing the payment pipeline from 4 days to 3 is that Ford gets an extra up-front pay-
ment equal to 1 day of float, or $250 million. We conclude that the present value of a
permanent reduction in float is simply the amount by which float is reduced.
However, you should be careful not to become overenthusiastic at managing the
float. Writing checks on your account for the sole purpose of creating float and earning
interest is called check kiting and is illegal. In 1985 the brokerage firm E. F. Hutton
pleaded guilty to 2,000 separate counts of mail and wire fraud. Hutton admitted that it
had created nearly $1 billion of float by shuffling funds between its branches and
through various accounts at different banks.

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