CASH MANAGEMENT GOLDEN BUCKETS CORPORATION: A CASE OF POOR CASH MANAGEMENT

Liquidity management

Cash Management

- is an aspect of current asset management that relates to the management of the optimal quantity of liquid assets (cash, marketable securities, and receivables) a firm should have on hand.

Cash Management - an aspect of liquidity management that relates to optimizing mechanisms for collecting and disbursing cash.

Liquidity management

- an aspect of liquidity management that relates to optimizing mechanisms for collecting and disbursing cash.

Cash Management

1. To have cash for transactions that affect normal operations, yet not have any excess because idle cash does not provide income to the firm.WHAT ARE THE GOALS OF CASH MANAGEMENT?

2. To minimize the amount of cash enough for the firm to maintain a "safety stock"; meet its compensating balance requirements; and to allow it to take advantage of bargains and discounts.WHAT ARE THE GOALS OF CASH MANAGEMENT?

TARGET CASH BALANCE

In order for the firm to meet its desired cash level, there has to be a trade-off between the opportunity costs of holding too much cash (the carrying costs) and the costs of holding too little cash (the adjustment costs or shortage costs)

TARGET CASH BALANCE

If a firm tries to keep its cash balance too low, it will run out of cash more often than is desirable necessitating it to sell marketable securities more frequently. This will result to high trading costs. As the cash balance increases, the trading costs will decrease.

In contrast, the carrying costs of holding cash will be low if the cash balance is low. Carrying costs will increase as the cash balance increases. The opportunity costs of earning interest income on Marketable Securities will increase because the firm is giving-up the opportunity to earn more interests by maintaining more cash.

Most often, news breaks about a firm's cash position because the company is running low on cash. That wasn't the case for oil companies in 2001. The Royal Dutch/Shell Group, for example, was earning $1.5 million in profit per hour and had about $12 billion in the bank. ExxonMobil has $11 billion in cash, and the industry as a whole had a $40 billion (and growing fast) stockpile according to analysts. These companies certainly had enormous cash reserves. What happens when these companies hold such large quantities of cash? We can learn about cash management using the simple case presentation in the next slides.

THE CASE OF GOLDEN BUCKETS CORPORATION

Case Background:

On January 1, 2015, Golden Buckets Corporation has a beginning cash balance of P1.8 Million. Each week, its cash outflows exceed its cash inflows by an average of P900,000. As a result, the cash balance drops to zero at the end of the 2nd week. Every end of the second week, Golden Buckets replenishes its cash by depositing P1.8 Million.

The interest rate that can be earned if cash is invested in Marketable Securities is 5% p.a. and the net cash outflows is the same everyday and is known with certainty.

The cost per trading is P1,200.

GOLDEN BUCKETS' PRESENT CASH MANAGEMENT STRATEGY:

To maintain a cash balance of P1.8 Million by selling its Marketable Securities and depositing to the bank the cash proceeds from the sale in the amount of P1.8 Million everytime its cash balance reaches zero.

THE CASE OF GOLDEN BUCKETS CORPORATION

Problem:

How can Golden Buckets minimize the cost of maintaining its cash and how much should be the optimum cash balance that Golden Buckets must maintain in order to minimize its carrying costs and opportunity costs?

CASE SOLUTION:

Using the BAT (Baumol-Allais-Tobin) Model, a classic model for analyzing cash management problems, we can determine the factors affecting cash management and solve Golden Bucket's poor cash management problem.

FORMULA: C* =

BAT MODEL:Total Cost = opportunity costs + trading costsOpportunity costs = (C/2) x RTrading costs = (T/C) x Fwhere:F = trading costs or fixed cost of making a securities trade to replenish cashT = total amount of new cash needed for transaction purposes over the relevant planning period, say one year.R = interest rate of the marketable securitiesC = cash balance

SOLUTION:

Step 1. By using different alternatives, determine the peso value of the opportunity cost of holding cash to determine how much interest is forgone.

Formula: Opportunity Cost = (C/2) x R

In the previous slide, The last column represents the interest income which Golden Buckets could have earned as the cash balance that it maintains increases. The interest income that the firm gives up because it holds more cash instead of investing them in Marketable Securities is called opportunity costs.

SOLUTION:

Step 2. Determine the total trading costs for the year by first determining how many times Golden Buckets will trade within the year. Formulae: T = C/2 x 52 weeks Total Trading Costs = (T/C) x F

In the previous slide, The last column represents the cost per trading everytime Golden Buckets convert its Marketable Securities into Cash. The cost that it incurs everytime it trades is called trading costs.

SOLUTION:

Step 3. Determine the cash balance with the lowest total costs for the year by adding the opportunity cost and trading costs. Formula: Total Costs = (C/2) x R + (T/C) x F

SOLUTION:

Step 4. After determining the cash balance with the lowest total costs for the year , determine the exact amount of the cash balance that should be maintained were the opportunity costs and trading costs are equal.

FORMULA:

C* = (2 x P42,800,000 x P1,200)/ 5%

= P1,498,800

SOLUTION:

Step 5. Check whether the cash balance that should be maintained results to equal values in opportunity costs and trading costs.

CONCLUSION:

1. Applying the BAT Model, we can determine the optimal cash balance that must be maintained by the firm where the total cost of maintaining cash is at its lowest value where the opportunity cost is equal to trading cost.

2. The amount of cash balance that should be maintained will vary depending on the interest rate of the Marketable Securities, the cost per trading and the average cash balance per period.

3. In the case of Golden Buckets Corporation, the optimal cash balance that they should maintain should be P1,498,800 where the opportunity cost of P37,470 is equal to the trading cost of P37,470 or a total cost of P74,940. 4. It is not enough for Golden Buckets to find a solution for determining its optimal cash balance, but it must seek for ways where it canprevent its cash flows to exceed its cash inflows by looking into the effects of the other current assets to its cash flows.

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