20-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
20-2
Chapter 20
Cash and Inventory Management
Chapter Outline
Cash Collection, Disbursement and Float
 Canada’s Payment System
 Managing Float
 Inventories and Cash Management

copyright © 2003 McGraw Hill Ryerson Limited
20-3
Collection, Disbursement & Float
• Float


Time exists between the moment a check is
written and the moment funds are deposited in
the recipient’s account.
This time spread is called the float.
 Payment
float occurs because a firm has
written a cheque, but it has not yet cleared the
bank.
 Availability float occurs because a firm has
deposited cheques to its account, but they have
not yet been cleared.
 Net Float is the difference between the payment
float and the availability float.
copyright © 2003 McGraw Hill Ryerson Limited
20-4
Collection, Disbursement & Float
• Float


For example: Assume your firm has $1 million
on deposit at the bank.
Your firm writes a cheque for $200,000 and
receives a cheque from a customer for
$120,000.
 Your
firm’s books show it has $920,000 in its
bank account:
 $1 million - $200,000 + $120,000 = $920,000
What do the bank’s records show your
firm as having on deposit?
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20-5
Collection, Disbursement & Float
• Float

Your bank is unaware of either cheque.
 The
cheque your firm wrote has not
cleared its account.
 The cheque your firm received has not
cleared its account either.

Thus, the bank shows your account as
having $1 million.
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20-6
Collection, Disbursement & Float
• Float

The difference between the balance on
your books and the balance at the bank
is $80,000 in your firm’s favour.
 That
is, your firm actually should have a
balance of $920,000 in its account.
 But because of time delays in processing
paper cheques, your firm actually gets the
use of $1 million.
copyright © 2003 McGraw Hill Ryerson Limited
20-7
Collection, Disbursement & Float
• Float

To summarize:
 The
payment float is $200,000 and the
availability float is $120,000.
 The net float is $80,000.
 Thus, your firm’s bank balance is $80,000
greater than the amount shown on its books.
Notice that your firm gains as a
result of the payment float and loses
as a result of the availability float.
copyright © 2003 McGraw Hill Ryerson Limited
20-8
Collection, Disbursement & Float
• Valuing


Float
The amount of float will depend on the size of
the cheque and the delay in collection.
For example:
 Your
firm writes $6,000 per day in cheques.
 It takes 7 days for a mailed cheque to clear your
firm’s bank account.
 The total delay is 7 days and payment float is
7 x $6,000 = $42,000.

Thus, on average, your bank balance will be
$42,000 greater than what is shown on your
books.
copyright © 2003 McGraw Hill Ryerson Limited
20-9
Collection, Disbursement & Float
• Valuing

Float
As a financial manager, you would like to
increase the payment float available to
your firm and decrease the availability
float.
 For
example, if you know it will take a
week to process cheques to suppliers,
your firm can get by on a smaller cash
balance.
 The smaller the cash balance, the more
funds your firm can hold in interest paying
investments.
copyright © 2003 McGraw Hill Ryerson Limited
20-10
Collection, Disbursement & Float
• Playing


the Float
Playing the float is the process of accelerating
your deposits and delaying your payments so
as to generate more float.
But be careful!
 Playing
the float too aggressively and writing
cheques on your account for the sole purpose of
creating float and earning interest is illegal.
 This behaviour is known as cheque kiting.
copyright © 2003 McGraw Hill Ryerson Limited
20-11
Canada’s Payments System
• How




Cheques are Cleared
Every day, Canadians use banking machines,
cheques, debit cards and preauthorized
payments to make payments totalling $127
billion.
Canada’s payments system lays down the
rules and procedures which guide the clearing,
exchange and settling of all types of payments.
The system is run by the Canada Payments
Association (CPA), a non-profit organization.
Its members are financial institutions that take
cheques and offer deposit facilities.
copyright © 2003 McGraw Hill Ryerson Limited
20-12
Canada’s Payments System
• How

Cheques are Cleared
The CPA runs the Automated Clearing
Settlement System (ACSS) and the
Large Value Transfer System (LVTS).
 ACSS
handles cheques and certain types
of automated payments.
 LVTS, introduced in 1999, is an electronic
wire transfer system.
copyright © 2003 McGraw Hill Ryerson Limited
20-13
Canada’s Payments System
• How

Payments are Cleared
There are three steps in the process of clearing
and settling payments:
1. Payment by cheque, debit card, direct deposit,
or other means.
2. Clearing, or the daily process by which the CPA
members exchange deposited payment items
and then determine the net amounts due each
other.
3. Settlement, or the procedure by which CPA
members use funds on deposit at the Bank of
Canada to meet their net payment obligations
to other member institutions.
copyright © 2003 McGraw Hill Ryerson Limited
20-14
Canada’s Payments System
• How
Cheques are Cleared
Canadians usually receive credit immediately
for the cheques they deposit, even if the
cheque is from the other side of the country.
 This is not so in the US and other countries,
where it can take several days before a bank
will clear a cheque through the client’s account.
 As a consequence, Canadian financial
managers have significantly fewer opportunities
to manage their firm’s float than US managers
do!

copyright © 2003 McGraw Hill Ryerson Limited
20-15
Managing Float
• Creating



and Managing Float
Payers attempt to create delays in the check
clearing process so that they can use their
cash for longer.
Recipients attempt to remove delays in the
check clearing process to get available cash
sooner.
Note that delays which help the payer, hurt the
recipient.
copyright © 2003 McGraw Hill Ryerson Limited
20-16
Managing Float
• Creating

and Managing Float
There are three sources of float which a
company can manage to increase (decrease)
the time it takes a cheque to clear the system:
Float – the time it takes to mail a cheque.
 Processing Float – the time it takes the
company to process the cheque upon receipt.
 Clearing Float – the time it takes the bank to
clear the cheque and adjust the firm’s account.
 Mail

The sum of these three sources of delay is the
collection time.
copyright © 2003 McGraw Hill Ryerson Limited
20-17
Managing Float
• Speeding

Up Collections
There are a number of methods your firm can
institute for speeding up its collections:
 Concentration
Banking is a system whereby
customers, instead of sending cheques to the
company, send them to a regional collection
centre.

This centre transfers funds to the firm’s bank.
 Lock
Box System is a system whereby
customers send payments to a post office box.

A local bank collects and processes the cheques
for your firm.
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20-18
Managing Float
• Speeding Up Collections
 Zero-Balance Accounts are regional
bank accounts to which just enough funds
are transferred daily to pay each day’s
bills.

Note that there are costs and benefits of
implementing any of the above systems.
 Thus,
the firm’s financial manager must
perform an analysis to determine if the
benefits of implementing offset the costs.
copyright © 2003 McGraw Hill Ryerson Limited
20-19
Managing Float
• Electronic
Payments and Receipts
More firms are giving up paper and
conducting their business electronically.
 Electronic Funds Transfer (EFT) is
payments made electronically instead of
using paper-based cheques.
 Electronic Data Interchange (EDI)
involves direct electronic information
exchange between enterprises,
eliminating the mailing and handling of
paper invoices.

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20-20
Managing Float
• Electronic
Payments and Receipts
Debit Cards involve an ATM card
(automated-teller-machine card) which
allows retail customers to transfer funds
directly from their bank accounts to the
retailer’s account.
 Preauthorized Payments or
Preauthorized Debits (PADs) involve a
customer authorizing a bank to pay
his/her bills automatically, instead of the
customer writing a cheque.

copyright © 2003 McGraw Hill Ryerson Limited
20-21
Managing Float
• Electronic

Payments and Receipts
There are several advantages of
conducting business electronically:
 Record
keeping and routine transactions
are easily automated, reducing time and
processing costs.
 The cost of such transactions is very low.
 Money moves instantly, and so float is
drastically reduced, which can generate
considerable savings.
copyright © 2003 McGraw Hill Ryerson Limited
20-22
Inventories and Cash Balances
• How


Much Cash Should a Firm Hold?
You now know some of the tricks of managing
your firm’s cash inflows and outflows.
However, how much cash should your firm
keep on hand?
 Remember,
cash pays no interest, so holding
cash will be a drag on your firm’s performance.
 However, investing all your firm’s cash in
securities, while it generates a return for the
firm, also involves a cost:

If the firm has to pay a bill, it must liquidate a
security and incur transactions costs.
copyright © 2003 McGraw Hill Ryerson Limited
20-23
Inventories and Cash Balances
• How


Much Cash Should a Firm Hold?
The art of cash management involves
balancing the costs and benefits.
Financial managers long ago recognized that
holding an “inventory of cash” is like holding an
inventory of materials.
 That
is, cash is just another material used in the
production process.
 Thus, it involves similar costs and benefits.


Holding excess inventory (or cash) is costly;
conversely, holding too little is also costly.
The key question, then is, “What is the right
amount of inventory (or cash) to hold?”
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20-24
Inventories and Cash Balances
• Managing Inventories
 There are two costs associated with
inventory:
 Order costs – administrative and delivery
charges associated with ordering inventory.
 Carrying Cost – costs associated with
holding and storing inventory:

The cost of space, insurance, losses due to
theft or spoilage and the opportunity cost of
the capital tied up in inventory which could
have been invested elsewhere.
copyright © 2003 McGraw Hill Ryerson Limited
20-25
Inventories and Cash Balances
• Managing

Inventories
The inventory problem comes down to
balancing these two costs:
As the firm increases its order size,
the number of orders falls and
therefore the order costs decline.
However, larger orders means an
increased inventory size and higher
carrying costs.
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20-26
Inventories and Cash Balances
• Managing
Inventories
If you look at Table 20.2 on page 616
of your text, you will see this trade-off
numerically depicted for a sample
company.
 Look at the carrying costs and the
order costs.

What is the optimal order
size for this firm?
copyright © 2003 McGraw Hill Ryerson Limited
20-27
Inventories and Cash Balances
• Managing Inventories
 The optimal order size for this firm is 60,000
bricks.
 At this order size, the total costs (order
costs plus carrying costs) are minimized at
$3,000.
 However, creating a table like Table 20.2 to
find the minimum total costs is a slow way to
calculate the optimal order size.
Is there an easier way?
copyright © 2003 McGraw Hill Ryerson Limited
20-28
Inventories and Cash Balances
• Managing Inventories
 You can calculate the Economic Order
Quantity (EOQ) using the formula below:
EOQ =


2 x Annual Sales x Cost per Order
Carrying Cost
The EOQ is the order size which minimizes
the total inventory costs.
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20-29
Inventories and Cash Balances
• Managing Inventories
 For our example, sales are 1 million bricks, order
costs are $90, carrying costs are $0.05 per brick.
EOQ =
=



2 x Annual Sales x Cost per Order
Carrying Cost
2 x 1 million x $90
0.05
= 60,000 bricks
Note this is the same answer as from Table 20.2.
copyright © 2003 McGraw Hill Ryerson Limited
20-30
Inventories and Cash Balances
• Managing Inventories

The EOQ model you have been
presented with is much simplified.
There
are numerous refinements which
could be made to make it more
accurate.
 However, these refinements should not
hide the important message that the
firm needs to balance its carrying costs
and order costs.
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20-31
Inventories and Cash Balances
• Managing
Inventories
Carrying costs include the costs of
storing the goods and the cost of the
capital tied up in inventory.
 So when storage costs or interest
rates are high, inventory levels should
be kept low.
 When the costs of restocking are high,
then inventory should also be high.

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20-32
Inventories and Cash Balances
• Managing Inventories of Cash
 This inventory model can also be applied to
the management of cash balances.
 That is, the cash management problem is just
like the inventory problem, but with a
redefinition of the variables:
 Instead
of order costs, the firm has
transactions costs when it sells securities to
raise cash.
 Interest rates replace carrying costs.
 Total cash outflows takes the place of annual
sales.
copyright © 2003 McGraw Hill Ryerson Limited
20-33
Inventories and Cash Balances
• Managing Inventories of Cash
 You can calculate the Initial Cash Balance
using the formula below:
Initial Cash Balance =

2 x Annual Cash Outflows x Cost per Sale of Security
Interest Rate
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20-34
Inventories and Cash Balances
• Managing Inventories of Cash
 Thus, the initial cash balance will be
higher if annual cash outflows are large
and when the cost of selling a security is
high.
 Conversely, it will be lower when interest
rates are high.
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20-35
Inventories and Cash Balances
• Managing Inventories of Cash
 Like the EOQ model, this model is much
simplified.
 Other more elaborate and realistic models
have been developed which will allow a firm to
more accurately manage its cash balances.
 Bear in mind that it would be very inefficient to
try to manage all of a firm’s cash flows.
 It
would use up too much of management’s time
for the benefits received.
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20-36
Inventories and Cash Balances
• Managing Inventories of Cash
 Thus, you want to think of cash management
rules and models as helping you to understand
the problems of cash management.
 Generally, though, they are not used for day-today management.
 Such rules probably could not yield the savings
resulting from a manager’s good judgment.
 Providing,
that is, that the manager understands
the trade-offs which have been discussed.
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20-37
Investing Idle Cash
• The



Money Market
The money market is the market for short-term
securities.
Firms use the money market to invest
temporary idle cash balances, so as to earn a
safe return on them.
These markets offer securities with
 Short
maturities.
 Low risk.
 High liquidity.
copyright © 2003 McGraw Hill Ryerson Limited
20-38
Investing Idle Cash
• The

Money Market
Some of the securities available in the money
market are:
 Treasury
bills.
 Commercial paper.
 Certificates of Deposit (CD’s).
 Repurchase Agreements (Repos or buybacks).
copyright © 2003 McGraw Hill Ryerson Limited
20-39
Summary of Chapter 20


The cash balance on your firm’s books will not
match the balance in its bank account.
When your firm writes a cheque, it takes time for
your balance to be adjusted downward.
 This

Conversely, when your firm receives a cheque,
it takes time for its balance to be adjusted
upward.
 This

is called payment float.
is called availability float.
The net float is the difference between the
payment float and the availability float.
copyright © 2003 McGraw Hill Ryerson Limited
20-40
Summary of Chapter 20



If you can play the float, your firm can hold
smaller cash balances and earn interest on the
extra cash it can invest.
There are a number of methods firms can use to
manage their float, including concentration
banking, lock-box banking and zero-balance
accounts.
There are costs and benefits of having
inventory.
 The
costs include carrying costs and ordering
costs.
copyright © 2003 McGraw Hill Ryerson Limited
20-41
Summary of Chapter 20





The EOQ model allows you to find the order
size of inventory which minimizes the costs of
having inventory.
Cash, like inventory, can be managed so as to
minimize the costs associated with holding it.
If a firm has temporary idle balances of cash, it
may invest them in the money market.
The money market offers short-term, low risk
and highly liquid securities.
This makes them ideal investments in which to
invest funds for short periods of time before
cash is needed.
copyright © 2003 McGraw Hill Ryerson Limited