Chapter-III

Managing Cash and Marketable Securities

Introduction
3.1 NATURE OF CASH

 Cash is the life-blood of any business and without it survival is very unlikely.… “What is
the one thing your business needs the most in order to survive and grow…… if you don't
have sufficient cash flow, your business could fail…..People and organisations will not
normally accept other than cash in settlement of their claims against the business. If a
business wants to employ people it must pay them in cash.... Cash to business is like fuel
to a car. You need to have enough in the tank to start the engine and you need to maintain
enough in the tank to keep it running. Now the car (your business) will take you where
you want to go. If you run out of gas – cash on hand – at any point along the way, well…
we all know what will happen.

 All purchases and payments are made through cash

 Cash by itself like other asset doesn’t produce goods and services
 At any point of time, receipts and payments can’t be synchronizing , thus a firm has to
have cash
 Cash is sensitive to changes in working capital
 A decrease in account receivable will increase cash position
 The determination of cash flow for a particular period is dependent upon working capital.
 Short term liquidity position of a firm is dependent on the amount of cash
 Loss due to shortage of cash can’t quantified easily
 Holding excess cash is a costly affair (it is idle cash with opportunity cost) …Cash is
often called a “nonearning asset.
3.2 Motives of Holding Cash
Transaction motive: to meet routine cash requirements to finance transaction in the normal course
of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc.
Precautionary motive (contingency needs): Cash inflows and outflows are unpredictable, with the
degree of predictability varying among firms and industries. Therefore, firms need to hold some cash
in reserve for random, unforeseen fluctuations in inflows and outflows. The more predictable the
inflows and out flows of cash for a firm, the less cash that needs to be held for precautionary needs.
Ready borrowing power to meet emergency cash drains also reduces the need for this type of cash
balance

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Speculative motive (opportunity needs): is the need to hold cash in order to be able to take
advantage of temporary opportunities like sudden decline in the price of raw material, attractive
interest rates, and (in the case of international firms) favorable exchange rate fluctuations.

However, these cash needs may be met by holding marketable securities or cash equivalent assets.
For the most part, firms don’t hold cash for the purpose of speculation. Consequently, we
concentrate only on the transactions and precautionary motives of the firm, with these needs being
met with balances held both in cash and in marketable securities.

When a firm holds cash in excess of some necessary minimum, it incurs an opportunity cost. The
opportunity cost of excess cash (held in currency and bank deposits) is the interest income that could
be earned in the next best use, such as an investment in marketable securities.

Compensating Motive:
 Is a motive for holding cash/near-cash to compensate banks for providing certain services or
loans
 Clients are supposed to maintain a minimum balance of cash at the bank which they cannot
use themselves.
An organization has to maintain a minimum cash balance to meet cash requirements.

ADVANTAGES OF HOLDING ADEQUATE CASH

 It prevents insolvency or bankruptcy
 It helps in fostering good relationship with creditors and suppliers.
 To take available trade discounts
 It leads to strong credit ratings. Adequate holdings of cash and near-cash assets can help
the firm maintain its credit rating by keeping its current and acid test ratios in line with
those of other firms in its industry. A strong credit rating enables the firm both to
purchase goods from suppliers on favorable terms and to maintain an ample line of low-
cost credit with its bank.
 It is useful to take advantage of favorable business opportunities, such as special offer
from suppliers or the chance to acquire another firm.
 To meet unexpected expenditure with the minimum strain, like strikes, fires or
competitors marketing campaigns, and to weather seasonal and cyclical downturns.
3.3 CASH MANAGEMENT

The basic objectives of cash management are two, these are: -

1. To meet the cash disbursement need (payment schedule)
2. To minimize funds committed to cash balance (Minimization of Idle cash).
These two objectives are conflicting and mutually contradictory and it is the task of cash
management to reconcile them.

1. Meeting the payment schedule- in the normal course firms have to make payment of cash on a
continuous and regular basis to supplier of goods, employees and so on. At the same time there

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 is a constant inflow of cash through collection from debtors and cash sales. And cash is therefore
“oil to lubricate the ever turning wheals of business, without it the process of grinds to stop”.

A basic objective of cash management is to meet the payment schedule i.e., to have sufficient
cash to meet the cash disbursement needs of the firm. Keeping large cash balances however
implies a high cost. Sufficient and not excessive cash can well realize the advantages of prompt
payment of cash.
2. Minimizing funds committed to cash balance
High level of cash balance has the advantages of prompt payment but has high costs. A low
level of cash may result in not keeping up payment schedule but has low cost.
Excessive cash balance reduces profitability whereas lower cash leads to insolvency. As excess
cash or shortage has its own costs, an optimal cash balance would have to be arrived. This
optimal cash balance has to be arrived at after taking into consideration of the future cash
inflows and out flows. Using cash budget can derive an optimal cash balance.
3.4 Cash conversion cycle (CCC)
Cash cycle: refers to the time taken from the time cash is paid to purchase raw materials till the time
it is received from customers. The cash operating cycle is the length of time, which elapses between
a business paying for its raw materials and the business’s customers paying for the goods made from
the raw materials.
It equals the debtor’s collection period plus the length of time for which stocks are held, less the
creditors’ payment period.
The operating cycle is represented by the following sequences of events.
1. Purchase of material inputs
2. Conversion of raw materials into w/p
3. Conversion of w/p into finished goods
4. Sale of finished goods, Account receivable
5. Conversation of account receivable into cash

Cash conversion cycle= Inventory conversion period + Receivables collection period –

Payables deferral period
OR Cash inflow delay _ Payment delay

Inventory Conversion Period: The average time required to convert materials into finished
goods

Inventory conversion period = Inventory

Sales per day

Receivables Collection Period: The average length of time required to convert the firm
‘receivables into cash

Receivables collection period = Receivables

Sales/365

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 Payables Deferral Period: The average length of time between the purchase of materials
and labor and the payment of cash for them.
Payables Deferral Period = Payables
Cost of goods sold/365

Example: The Corporation has an inventory conversion period of 75 days, a receivables

collection period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the firm’s cash conversion cycle?
b. If annual sales are $3,421,875 and all sales are on credit, what is the firm’s investment
in accounts receivable?
c. How many times per year does turn over its inventory?

SHORTENING THE CASH CONVERSION CYCLE

Given these data, RTC knows when it starts producing a computer that it will have to finance the
manufacturing costs for a 67-day period. The firm’s goal should be to shorten its cash conversion
cycle as much as possible without hurting operations. This would improve profits, because the
longer the cash conversion cycle, the greater the need for external financing, and that financing has
a cost.

The cash conversion cycle can be shortened (1) by reducing the inventory conversion period by
processing and selling goods more quickly, (2) by reducing the receivables collection period by
speeding up collections, or (3) by lengthening the payables deferral period by slowing down the
firm’s own payments. To the extent that these actions can be taken without increasing costs or
depressing sales, they should be carried out.

Cash turnover is the number of times firm’s cash is used during each year and the higher cash
turnover, the less cash the firm requires. Therefore, the firm should try to maximize the cash
turnover but it must maintain a minimum amount of operating cash balances so that it doesn’t run
out of cash
Cash turn over = Number of days in a year
Cash cycle

 High turnover is desirable since it reduces firm’s average cash balance and holding costs.
 Minimum cash balance( Ave. Cash bal) = Total annual outlay
Cash turn over

The operational implication of the minimum cash requirement is that if the firm has an operating
minimum cash balance it would be able to meet its obligation when they become due. But the
minimum operating cash involves cost in terms of the earning forgone from investing it temporarily
(i.e., opportunity cost). Also the firm will have to pay a cost for this amount.
Example: Over the past year, X company’s accounts receivable have averaged 80 day sales and
inventories have averaged 60 days. The company has paid its creditors, on average, 25 days after

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receiving the bill. Production is evenly spread over the year and the company expects to spend birr
18 million during the year for materials and supplies
1. Compute the following
Cash cycle
Cash turnover
Minimum cash balance
2. What is the birr cost of tying up the fund if the company’s opportunity cost is 20%?
Solution
1. A. Cash cycle = 80 + (60-25) = 115 days
B. Cash turnover = 365/115 = 3.18 times
C. Minimum cash balance = 18,000,000 = birr 5,750,799
3.13
2. Birr cost = 5,750,799 x 0.2 = birr 1,150,160

CASH MANAGEMENT STRATEGIES (techniques)

 The basic strategies that can be employed are:
A. Stretching (Extending) payments of accounts payable
B. Efficient inventory production management
 Increasing the raw material turnover by using more efficient inventory control techniques
Example: JIT- its reduces the idle investment
 Decreasing the production cycle through better production planning, scheduling and
control techniques. It will lead to an increase in WIP turn over
 Increasing finished goods turnover though better for casting of demand and better
planning of production.
C. Speedy collection of account receivable
 Credit terms- reducing the credit period
 Credit standards- increase the standards to reduce credit customers
 Collection policy- centralized and decentralized collection
D. Combined cash management strategies
Each one of the above strategies if used results in saving. Supposing if all the strategies are effected
simultaneously then it is called combined cash management strategies.
 Efficient cash management implies minimum idle cash balances consistent with the need
to pay bills when they become due.
The three basic strategies related to accounts payable, inventory and accounts receivable leads to a
reduction in the cash balance but they imply certain problems to the management.
 If the accounts payable postponed too long, the credit standing of the firm may be adversely
affected (Signify poor financial position)
 A low level of inventory may result in stoppage of production or not enough finished goods
stock to meet the demand (Result in out off stock)
 Restrictive credit terms, credit standards and collection policy may jeopardize (Lower sales).
These implications will constantly kept in view while working out cash management strategies.

MANAGING CASH COLLECTION AND DISBURSEMENT

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Float: Difference between bank cash balance and book cash balance
Float= Firm’s bank balance- firm’s book balance

Float

Disbursement float Collection float

 Checks received by the firm

 Checks written by firm  Increase in book cash but no
 Decreased in book cash but no immediate immediate change in bank
Change in bank balance balance

Net float= disbursement float + collection float

Example: Disbursement float

XYZ co. currently has birr 1,000,000 on deposit with its bank. The book balance also shows birr
1,000,000. Assume that XYZ co. Purchased materials and make payments by writing a check for birr
100,000
 The book balance is immediately adjusted to $ 900,000 when the check is issued.
 The bank balance will not decrease until the check is presented to XYZ’s bank by the
supplier or his bank.
Disbursement float = Bank balance – book balance

= 1,000,000 – 900,000 = 100,000

Collection float

Consider the same example above, but instead of payment, the firm receives a check from a
customer for $ 200,000 and deposits the check at its bank.
Book balance is adjusted immediately to $ 1,200,000
Bank balance will not increase immediately until XYZ’s bank present the check to the customer’s
bank and received the amount
Collection float = Bank balance - book balance

= 1,000,000 – 1,200,000 = -200,000

Net float = 100,000 - 200,000 = -100,000

Float result an opportunity cost because the cash is not available for use during the time checks are
tied up in the collection process.
FLOAT MANAGEMENT
It involves controlling the collection and disbursement of cash. The objective in cash collection is to
speed up collections and reduce the lag between the time customers pay their bills and the time the
cash becomes available. The objective in cash disbursement is to control payments and minimize the
firm’s costs associated with making payments.

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Total collection or disbursement times can be broken down into three parts mailing time, processing
delay, and availability delay.
1. Mailing time is the part of the collection and disbarment process during which
checks are trapped in the postal system
2. Processing delay is the time it takes the receiver or the check to process the
payment and deposit it in a bank for collection
3. Availability delay refers to the time required to clear a check through the banking system.
Speeding up collections involves reducing one or more or these components. Slowing up
disbursement involves increasing one of them. We will describe some procedures for managing
collection and disbursement times later.
The various collection and disbursement method that a firm employ to improve its cash management
efficiency constitutes two sides of the same coin. They exercise a joint impact on the overall
efficiency of cash management. The general idea is that the firm will benefit by “speeding up” cash
receipts and “s-l-o-w-i-n-g d-o-w-n” cash payouts. The firm wants to speed up the collection of
accounts receivable so that it can have the use of money sooner. Conversely, it want to pay accounts
payable as late as is consistent with maintaining the firm’s credit standing with suppliers so that it
can make use of the money it already has. Today, most companies of reasonable size use
sophisticated techniques to speed up collections and tightly control disbursements.

There are a specific techniques and process for speedy collection of receivable and slowing
disbursements.
A. Speedy cash collections
In managing cash efficiently the cash inflow process can be accelerated through systematic planning
and refined techniques. In the first place the customer should en courage to pay as quickly as
possible secondly the payment from customers should be converted into cash without any delay.
1. Prompt payment by customer- one way to insure prompt payment by customer is prompt billing.
Customers have different payment habits. Some pay their bills on the discount date or the final date
(or later), while others pay immediately up on receipt of an invoice. In any event, accelerated
preparation and mailing of invoices will result in faster payment because of the earlier invoice
receipt and resulting earlier discount and due dates.
2. Early conversion of payment into cash-once the customers makes the payment by writing a
check in favor of the firm the collection can be expedited (speed up) by prompt encashment of
the check
An important aspect of cash management is the reduction of deposit float. This is possible if a firm
adapts decentralized collection. The principal methods of decentralized collections are:
1. Lock box system
2. Concentration banking

i. Lock box system

The single most important tool for accelerating the collection of remittances is the lock box. A
company rents a local post office box and authorizes its bank to pick up remittances in the box.
Customers are billed with instructions to mail their remittances to the lock box.

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In the typical lock box system, the local bank collects the lock box checks from the post office
several times a day. The bank deposits the checks directly to the firm’s account. Details of the
operation are recorded (in some computer usable form) and sent to the firm.
A lock box system reduces mailing time because checks are received at a nearby post office instead
of at corporate head quarters. Lock box also reduce the processing time because the corporation
doesn’t have to open the envelopes and deposit checks for collection. In all, a bank lock box should
enable a firm to get its receipts processed, deposited and cleared faster than if it were to receive
checks at its headquarters and deliver them itself to the bank for deposit and clearing.
ii. Concentration banking
The firm that uses a lock box net work as well as the one having numerous sales out lets which
receive funds over the counter have something in common. Both firms will find themselves with
deposit balances at a number of regional banks. Each firm may find it advantageous to move part, or
all, of these deposits to one central location, which is known as a concentration bank. This is the
process of cash concentration. Cash concentration is the movement of cash from lock box or field
banks into the firm’s central cash pool residing in a concentration bank.
 Improves control over inflows and out flows of corporate cash. The idea is to put all of your
eggs (or in this case, cash) into one basket and them to watch the basket.
 Reduces idle balances- that is keeps deposit balances at regional banks on higher than necessary
to meet transaction needs. Any excess funds would be moved to the concentration bank.
 Allows for more effective investments. Pooling excess balances provides the larger cash
amounts needed for some of the higher yielding, short-term investment opportunities that
require a larger minimum purchase.
Other approaches to cash collection exist. One that is becoming more common is the preauthorized
payment arrangement. With this arrangement; the payment amounts and payment dates are fixed in
advance. When the agreed-up on date arrives, the amount is automatically transferred from the
customer’s bank account to the firm’s bank account, which sharply reduces or even eliminates
collection delays. The same approach is used by firms that have on-line terminals, meaning that
when a sale is rung up, the money is immediately transferred to the firm’s accounts.

B. S-L-O-W-I-N-G D-O-W-N DISBURSMENTS

Form the firm’s point of view, disbursement float is desirable, so the goal in managing disbursement
float is to slow down disbursements as much as possible. To do this, the firm may develop strategies
to increase mail float, processing float and availability float on the checks it writes. Beyond this,
firms have developed procedures for minimizing cash held for payment purposes.

a. Increasing disbursement float

As we have seen, float in terms of slowing down payments comes from the time involved in mail
delivery, check processing and collection of funds.

Disbursement float can be increased by writing a check on a geographically distant bank.

 Mailing checks from remote post office is another way for firms to slow down disbursements.
Tactics for maximizing disbursement float are debatable on both ethical and economic
grounds.
 Payment terms very frequently offer a substantial discount for early payment. The discount is
usually much larger than any possible savings from “playing the float game”

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  Suppliers are not likely to be fooled by attempts to slow down disbursements. The negative
relations with suppliers can be costly.
In broader terms, intentionally delaying payments by taking advantage of mailing times or
unsophisticated suppliers may amount to avoiding paying bills when they are due, an unethical
business procedure.

b. Controlling disbursements
We have seen that maximizing disbursement float is probably poor business practice. However, a
firm will still wish to tie up as little cash as possible in disbursements. Firms have therefore
developed systems for efficiently managing the disbursement process. The general idea in such
systems is to have no more than the minimum amount necessary to pay bills on deposit in the bank.

I) Zero-balance accounts: -

With this system, the firm, in cooperation with its bank, maintains a master account and a set of sub
accounts when a check written on one of the sub accounts must be paid the necessary funds are
transferred in from the master account.

The key is that the total amount of cash held as a buffer is smaller under the zero balance
arrangement which frees up cash to be used elsewhere.

ii) Controlled disbursement accounts: -

With a controlled disbursement account system almost all payments that must be made in a given
day are known in the morning. The bank informs the firm of the total and the firm transfers (usually
by wire) the amount needed.

A disbursement account to which the firm transfers an amount that is sufficient to cover demands for
payment.

DETERMINING THE TARGET CASH BALANCE

The target cash balance involves a trade-off between the opportunity costs of holding too much cash
(the carrying costs) and the costs of holding too little (the shortage costs, also called adjustment
costs). The nature of these costs depends on the firm’s working capital policy.

 Cash holding
Benefit- liquidity
Cost- interest for gone
If a firm tries to keep its cash holding too low, it will find itself running out of cash more often than
is desirable, and thus selling marketable securities (and perhaps later buying marketable securities to
replace those sold) more frequently than would be the case if the cash balance were higher. Thus
trading costs will be high when the cash balance is small. These costs will fall as the cash balance
becomes larger.

In contrast, the opportunity costs of holding cash are very low if the firm holds very little cash. These
costs increase as the cash holdings rise because the firm is giving up more and more in interest that
could have been earned.

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 Cost of holding cash ($)

Total cost of holding cash

Opportunity cost

Trading cost

Size of cash balance (c)

Optimal size of cash
balance
Trading costs are increased when the firm must sell securities to establish a cash balance.
Opportunity costs are increased when there is a cash balance because there is no return on cash.

1. THE BAT MODEL

The Baumol-Allais-Tobin (BAT) model is a classic means of analysing our cash management
problem. It is a straight forward model and, more generally, current asset management

Implicitly, we assume that the net cash out flow is the same every day and that it is known with
certainty. These two assumptions make the model easy to handle.

Because transactions costs (for-example, the brokerage costs of selling marketable securities) must
be incurred whenever cash is replenished, establishing large initial balances will lower the trading
costs connected with cash management. However, the larger the average cash balance, the greater the
opportunity cost (the return that could have been earned on marketable securities)

To determine the optimal strategy, a company needs to know the following things.

F= The fixed cost of making a securities trade to replenish cash

T= The total amount of new cash needed for transactions purpose over the

relevant planning period, say, one year

R= The opportunity cost of holding cash. This is the interest rate on marketable

securities.

C= Amount of cash raised by selling securities or borrowing, evenly spaced.

The opportunity costs: - To determine the opportunity costs of holding cash, we have to find out
how much interest is forgone. A company has, on average, C/2 in cash. This amount could be

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earning interest at rate R. So the total dollar opportunity costs of cash balances are equal to the
average cash balance multiplied by the interest rate.
Opportunity cost= (C/2) x R

The trading costs: - To determine the total trading costs for the year, we need to know how many
times a company will have to sell marketable securities during the year. It is determined by T/C. It
costs F dollars each time; so trading costs are given by
Trading costs= (T/C) x F

The total cost: - Now that we have the opportunity costs and the trading costs, we can calculate the
total cost by adding them together
Total cost= opportunity cost + Trading costs

= (C/2) x R + (T/C) x F

As the figure is drawn, the optimal size of the cash balance, C*, occurs right where the two lines
cross. At this point, the opportunity costs and the trading costs are exactly equal. So at C*, we must
have that: -

Opportunity costs = Trading costs

(C*/2) x R = (T/C*) xF

C*XC* = (2T xF)

R
2
C* = (2T x F)
R

C* = √2T x F
R
The BAT model is possibly the simplest and most stripped-down sensible model for determining the
optimal cash position. Its chief weakness is that it assumes steady, certain cash out flows

Example: - ABC co. has cash out flows of $100 per day, seven days a week. The interest rate is 5
percent, and the fixed cost of replenishing cash balances is $10 per transaction. What is the optimal
cash balance? What is the total cost? T= 365 x days x 100 = $ 36,500

C* = (2T x F) = (2x36,500 x 10) = $ 14.6 million

R 0.05

= $ 3,821

The average cash balance (C*/2) is $ 3,821/2 = $ 1,911, so the opportunity cost is $ 1,911 x 0.05 = $
96. Because a company needs $ 100 per day, the $ 3,821 balance will last $3,821/100 = 38.21 days
the firm needs to re supply the account 365/38.21 = 9.6 times per year, so the trading (order) cost is $
96. The total cost is $192.

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 THE MILLER-ORR MODEL: A MORE GENERAL APPROACH
It is a cash management system designed to deal with cash inflows and out flows that fluctuate
randomly from day to day. With this model, we again concentrate on the cash balance, but, in
contrast to the situation with BAT model, we assume that this balance fluctuates up and down
randomly and that the average change is zero

Cash U*

U* is the upper Cash

balance
control limit
C*
L is the lower

control limit

The target cash LTime

balance is C*
X Y

The basic idea: The figure shows how the system works. It operates in terms of an upper limit to the
amount of upper limit to the amount of cash (U*) and a lower limit (L), and a target cash balance
(C*). The firm allows its cash balance to wander around between the lower and upper limits. As long
as the cash balance is somewhere between U* and L, nothing happens.

When the cash balance reaches the upper limit (U*), such as it does at point X, the firm moves U*-
C* dollars out of the account and into marketable securities. This action moves the cash balance
down to C*. In the same way, if the cash balance falls to the lower limit (L), as it does at point Y, the
firm will sell C*-L worth of securities and deposit the cash in account. This action takes the cash
balance up to C*

Using the model:- To get started, management should set the lower limit (L). This limit essentially
defines a safety stock; so where it is set depends on how much risk of cash shortfall the firm is
willing to tolerate. Alternatively, the minimum might just equal a required compensating balance.

As with the BAT model, the optimal cash balance depends on trading costs and opportunity costs.
Once again, the cost per transaction of buying and selling marketable securities, F, is assumed to be
fixed. Also, the opportunity cost of holding cash is R, the interest rate per period on marketable
securities.

The only extra piece of information needed is 2 , the variance of the net cash flow per period. For
our purposes, the period can be anything, a day or a week, for example, as long as the interest rate
and the variance are based on the same length of time.

Given L, which is set by the firm Miller and Orr show that the cash balance target C*, and the upper
limit, U*, that minimize the total costs of holding cash are:
C* = L+ (3/4 x F x 2 /R) 1/3

U* = 3 x C* - 2XL

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Also, the average cash balance in the Miller- Orr model is :
Average cash balance = (4 x C* -L)
3

For example, suppose F= $ 10, the interest rate is 1 percent per month, and the standard deviation of
the monthly net cash flow is $ 200. The variance of the monthly net cash flow is:
2 = $ 2002 = $40,000
We assume a minimum cash balance of L= $ 100. We can calculate the cash balance target, C*, as:

C* = L + (3/4 x F x 2/R) 1/3

= 100+ (3/4 x 10 x 40,000/1%)1/3

= 100+ (30,000,000 (1/3))

= $ 411

The upper limit, U* , is thus:

U* = 3 x C* - 2 XL

= 3 x $411 –2x100

= $ 1,033

Finally, the average cash balance will be:

Average cash balance = (4 x C* -L)

= (4 x $ 411 – 100)
3

= $ 515

Implications of the BAT and Miller Orr models

Our two cash management models differ in complexity but they have some similar implications. In
both cases, all other things being equal, we see that.

1. The greater the interest rate, the lower is the target cash balance

2. The greater the order cost, the higher is the target balance

These implications are both fairly obvious. The advantage of the Miller-Orr model is that it improves
our understanding of the problem of cash management by considering the effect of uncertainty as
measured by the variation in net cash inflows.

The Miller-Orr model shows that the greater the uncertainty is (the higher 2 is), the greater is the
difference between the target balance and the minimum balance. Similarly, the greater the
uncertainty is, the higher is the upper limit and the higher is the average cash balance. These
statements all make intuitive sense. For example, the greater the variability is, the greater is the
chance that the balance will drop below the minimum. We thus keep a higher balance to guard
against this happening.

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 Investing idle cash
If a firm has a temporary cash surplus, it can invest in short term securities. The market for short-
term financial assets is called the money market. The maturity of short-term financial assets that
trade in the money market is one year or less. Firms have temporary cash surplus for various reasons.
Two of most important are the financing of seasonal or cyclical activities of the firm and the
financing of planned or possible expenditures.

Seasonal or cyclical activities:- Some firms have predictable cash flow pattern. They have surplus
cash flows during part of the year and deficit cash flows the rest of the year. Such firm’s may buy
marketable securities when surplus cash flows occur and sell marketable securities when deficits
occur. Of course, bank loans are another short-term financing device.

Planned or possible expenditures: firms frequently accumulate temporary investments in

marketable securities to provide the cash for a plant construction program, dividend payment, or
other large expenditure. Thus firms may issue bonds and stocks before the cash is needed, investing
the proceeds in short-term marketable securities and then selling the securities to finance the
expenditures. Also firms may face the possibility of having to make a large cash outlay. An obvious
example would involve the possibility of losing a large lawsuit. Firms may build up cash surplus
against such a contingency.

Selecting investment opportunities

A firm can invest its, excess cash in many types of securities or short-term investment opportunities.
As the firm invests its temporary cash balance, its primary criterion in selecting a security or
investment opportunities will be its quickest convertibility into cash, when the need for cash arises.
Besides this, the firm would also be interested in the fact that when it sells the security or liquidates
investment, it, at least gets the amount of cash equal to investment out lay. Thus, in choosing among
alternative investment, the firm should examine three basic features of security safety, maturity and
marketability.

Safety: usually, a firm would be interested in receiving as high a return on its investment as is
possible. But the higher return yielding securities or investment alternatives is relatively more risky.
The firm would invest in very safe securities, as the cash balance invested in them is needed in near
feature. Thus, the firm would tend to invest in the highest yielding marketable securities subject to
the constraint that the securities have acceptable level of risk. The risk referred here is the default
risk. The default risk means the possibility of default in the payment of interest or principal on time
and in the amount promised.

Maturity: It refers to the time period over which interest and principal are to be made.

 Long term security – more fluctuation in interest rate

- More risky
 Short term security
 For safety reasons it is preferred by the firm for the purpose of investing excess cash.
Marketability: It refers to convenience and speed with which a security or an investment can be
converted into cash. The two important aspects of marketability are price and time.

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Types of short-term investment opportunities
 Treasury bills
 Commercial papers
 Certificate of deposits
 Bank deposits
 Inter-corporate deposits
 Money market mutual funds

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