Managing Cash Balances (2) – An Overview of Financial Markets

1 Introduction

This chapter is outlining the banking system, the different types of banks, and the way that the stock market operates from the point of view of the financial manager.

2 Types of banks

There are various types of banks in the banking system, each of which performing a different function:

Retail/Commercial banks - these are the ‘high street banks’ that most of us use. They provide basic banking services, such as providing a current account, providing credit cards, offering deposit accounts earning interest, and providing loans.

Investment banks - these banks exist to assist both companies and governments in the raising of money, e.g. advising and assisting on the issuing of shares and debt finance

Central banks - each country has a central bank that not only supervises the operations of the commercial banks but also implements the monetary policies of the government, fixes the official interest rates, and act as banker to the government and to the other banks. The central bank is also responsible for issuing paper money and act as ‘lender of last resort’ to the commercial banks.

3 Financial intermediaries

There are always many people who have spare cash and wish to deposit it and earn interest, and also many people who wish to borrow money (and will therefore have to pay interest). It is obviously possible for people with spare cash to lend directly to those wishing to borrow cash, but this has not been common because it is difficult to match:

• the amounts individuals want to lend and amounts others want to borrow.
  

• the periods some people want to lend for to the periods others want to borrow.
  

Banks therefore perform an important function as financial intermediaries of pooling deposits from customers and then from the pool can lend different amounts for different periods. Banks will also have expertise at assessing the risk of lending money to various borrowers and this risk management is also of use to depositors.

Recently, there has been some growth in peer-to-peer lending websites which apply technology to finance (Fintech) to match up people who have cash to lend with individuals or companies wanting to borrow. Because the banking intermediary is cut out investors lending cash can get higher rates than they would from a savings account, while borrowers often pay less than with a conventional loan. The sites themselves profit by taking a fee. However, there are greater risks of bad debts and it can be difficult to retrieve funds as easily as with a conventional bank savings account.

Other financial intermediaries include pension funds and unit trusts (mutual funds).

4 The benefits of financial intermediaries

Financial intermediaries perform the following role

• Aggregation: for example, many small deposits can be used to make several large loans
  

• Maturity transformation: for example, many deposits of different durations allow loans of long duration
  

• Risk transformation: for example, banks take money from depositors and depositors only face the risk of the bank getting into trouble (often rescued by governments). The banks risk some their many borrowers getting into financial trouble but if properly managed this can be survived as the banks will still have many viable customers.
  

5 Ways in which a company may invest money in order to earn interest

If a company has spare cash that they want to invest in order to earn interest, there are various opportunities open to them.

Generally there is a relationship between risk and return. For example:

Placing money in a bank deposit account from where it can be immediately withdrawn will provide low income but high safety as the bank is unlikely to fail, the balance will not go down and the money is instantly available.

Investing temporary surplus cash in shares would be very risky because dividends are not guaranteed, the share price can be very volatile and the investment could turn out to be worthless if the company failed, However, if the company whose shares were invested in did well the investor could make a large. This type of investment of r cash balances is so risky that few companies would do it.

The main homes for surplus cash are:

• Bank deposits - Money is deposited with the bank, usually (but not always) for a fixed period of time, and usually (but not always) at a fixed rate of interest. Withdrawing the money early is usually allowed (subject to the terms of the deposit), but there will be a penalty for doing so.
  

• Certificates of deposit (CD’s) - This is money deposited with a bank for a fixed period of time and at a fixed rate of interest. The CD is the receipt provided by the bank and this CD is usually negotiable. This means that the company is able to sell the CD to someone else, and the purchaser will then receive the interest and the repayment of the deposit on the due date.
  

• Government stocks -These are bonds issued by the government. The government pays fixed interest and repays the investment after a fixed period of time. As with CD’s these bonds are negotiable and may be sold to others at any time - but their price is variable and the investor can make capital losses.
  

• Local authority bonds - These are similar to government stocks, except that they are issued by local authorities as a way for them to borrow money
  

• Bills of exchange – A bill is a signed, unconditional written order directing another party to pay a specified sum on demand or at a stated or determinable future date. A written promise to pay is a promissory note. Negotiable bills can normally be sold at a discount before maturity to obtain cash sooner. A bill may expressly provide for interest; it is not necessarily interest-free. Payment risk depends on the parties liable on the bill; a bank’s acceptance can improve credit quality, but bank backing is not automatic.

6 Money markets

Money markets facilitate the borrowing and lending of money for periods ranging from overnight until a year. They are used by banks and large companies.

There are several different markets:

• Deposits (simple bank deposits) - These will pay interest and often they allow money to be withdrawn immediately. Sometimes they can be term accounts which ties up cash for a fixed term, like three months. Sometimes they require some days or weeks notice for a withdrawal to be made. Term and notice accounts pay higher rates of interest than instant access accounts but, of course, they are not as flexible.
  

• Bills – Treasury bills are short-term government securities, normally issued at a discount and repaid at face value; they do not pay a coupon. A trade bill of exchange is a signed, unconditional written order to another party to pay a specified amount on demand or at a stated future date. It is a different instrument and may include an interest term.

• Commercial paper - Simple IOUs evidencing a debt. They can be held until the loan matures or could be sold to another entity. /

• Certificates of deposit -These can be issued to bank customers who deposit substantial amounts. If a customer needs to retrieve cash earlier than the terms of the deposit, the CD can be sold on the market. /

• Repo market - A repurchase agreement (repo) is a short-term secured loan: one party sells securities to another and agrees to repurchase those securities later at a higher price. The securities serve as collateral. The difference between the securities’ initial price and their repurchase price is the interest paid on the loan, known as the repo rate. The repo market allows financial institutions that own lots of securities (e.g. banks and hedge funds) to borrow cheaply and allows parties with lots of spare cash to earn a small return on that cash without much risk, because securities, often government securities, serve as collateral.
  

• Inter-bank market – Banks lend to and borrow from one another. Rates depend on currency, term and credit risk. Sterling contracts commonly reference SONIA (Sterling Overnight Index Average); US dollar contracts commonly reference SOFR. LIBOR ceased permanently in September 2024.

7 Bank finance and the bank–customer relationship

• A loan normally has agreed repayment dates; an overdraft permits drawings up to a limit and is normally repayable on demand. Agree the rate, fees, security, covenants, review dates and repayment conditions.

• A positive bank deposit makes the bank a debtor to its customer; when the customer borrows, the customer is the debtor. The account contract and mandate govern the relationship.

• The bank should act on valid payment instructions with appropriate care and protect customer information, subject to legal duties and permitted disclosures. The customer must follow agreed security procedures and repay borrowing and charges. Read the actual agreement.

7.1 Risks of relying on short-term finance

• Short-term funding for permanent assets creates refinancing risk: a facility may be withdrawn or renewed on worse terms. Variable interest rates can also increase cost.

• An overdraft is flexible for temporary fluctuations, but its on-demand nature makes it a poor sole source of finance for long-lived assets. Match the financing period to the underlying need and maintain contingency headroom.

8 Managing cash surpluses and deficits

8.1 Cash surpluses

From time-to-time, when a company carries out its cash flow budget it might find that it has cash surpluses ie an amount of cash that will not be needed for either day-to-day operations or for capital investment for some time. Perhaps the cash has been earmarked to pay a tax bill in several months' time; perhaps an asset has been sold and a replacement will not be bought for some months; perhaps really good profits have been made and the company has as yet no plans for spending the cash. Seasonal trading can also produce surpluses during good months but these are then used up during lean months.

It would be wasteful to simply let surplus cash sit in a non-earning bank account. Instead it should be invested to earn income. When identifying cash surpluses and deciding on investment strategies the company should be careful not to tie up too much cash for too long or too inflexibly. If something suddenly goes wrong in the company (for example, a large receivable going bad), the cash surplus could soon turn into a cash deficit and the company would need to make use of its invested cash.

Broadly, surplus cash can be invested as in the ways outlined above, under money markets. In addition, companies could invest in Government bonds or in shares in listed companies. However, although these can be quickly and easily resold they can fall in value as well as rise and the company could find that they do not realise enough cash.

If a company finds it has a permanent cash surplus and can find no acceptable way in which to invest more money in non-current assets to grow the business, it is generally considered wrong for a company to hang onto that surplus cash indefinitely in case 'something turns up'. If the company had no convincing plans for spending the cash then it should return money to investors who can then, individually, decide how to invest it. Companies can return cash to investors by paying additional dividends or by buying up its own shares from investors.

8.2 Investing surplus cash within policy

Cash earmarked for a tax payment should be available in full on the due date; a high return does not justify putting that payment at risk. Longer-term surplus may permit a different balance of objectives.

Example: policy permits at most $50,000 with one institution and a maximum 30-day term. A proposed $60,000 90-day deposit breaches both limits. Choose approved institutions/terms within the limits or seek authorised approval to change policy; do not bypass the limits.

8.3 Types of investment risk

Diversifying across suitable issuers can reduce unsystematic risk. It cannot eliminate systematic risk. Select investments consistent with the cash need, risk tolerance and policy limits.

8.4 Cash deficits

There are many reasons why a company could find itself short of cash:

• An error in its cash flow forecast
  

• A large customer failing to pay for its purchases
  

• Deciding to upgrade machinery
  

• Deciding to take-over a rival at short notice
  

• Seasonal trading so that the company has to buy in lots of stock in preparation for high seasonal sales.
  

Some deficits can be forecast (like those caused by seasonal trading); some are nasty surprises (like a customer going broke).

The main ways of dealing with deficits are:

• Bank overdrafts. Here, the bank allows customers to draw out more money from their current bank account than is actually there. The balance 'goes negative' or 'into the red'. Overdrafts should be agreed in advance as the bank is under no obligation to allow the arrangement. Overdrafts offer a very flexible borrowing facility and borrowers can repay whenever they want, so they are ideal for short-term cash problems. Why arrange a loan for a year, costing a year's worth of interest, if the company might be able to repay after three, four or five months? The downside is that overdrafts are repayable on demand so if a bank begins to get worried about a customer's ability to repay it might 'call in' the overdraft to get its money back before other creditors. This can cause the business to fail. Overdrafts are ideal for cash deficits caused by seasonal trading because they are needed for only a short time and the cash deficit should change into a surplus allowing the overdraft to be repaid.
  

• Term loans. These need to be arranged in advance and the bank will require cash flow projections showing how their customer will repay the borrowings. They are very suitable for buying new machinery as the machinery should produce profits from which repayments can be made.
  

• Injections of permanent capital. Sometimes the deficit will not repair itself. For example, if a business has spent a lot developing a new product which turns out to be a flop. Or, a business a lost money because of an economic recession. In cases like these a more permanent injection of cash is needed and the company will turn to its shareholders. Effectively the business is saying 'Pay in more capital or the business will fail and you will lose your investment'. Of course, even after more capital is injected the business could still fail and Investors have to decide if the gamble is worthwhile.
  

9 Cash management models - the Baumol model

9.1 How the Baumol model works

Baumol applies the inventory EOQ idea to cash transfers. Cash is obtained in a fixed-size transfer (for example by selling short-term investments), spent steadily, then replenished when exhausted. The balance falls from the transfer amount towards zero; the average balance is half the transfer amount.

A larger transfer means fewer transactions but more interest forgone on cash held. A smaller transfer means more transaction costs but less idle cash. The model balances these costs to find an optimum transfer size. FFM requires explanation, not Baumol calculations.

• Assumptions/limitations: predictable, constant cash usage; known transaction costs and interest rate; immediate replenishment. It does not handle irregular cash inflows/outflows or uncertainty well and does not itself provide a precautionary buffer. Real businesses need forecasts and contingency liquidity.

9.2 Choosing a practical liquidity level

Consider the reliability of receipts, supplier/payroll dates, unexpected expenses and access to finance. There is no single appropriate cash balance for every organisation.

10 Chapter 8 questions

Question 1

Is the following statement true or false?

The Baumol model estimates the optimum cash transfer amount by balancing transaction costs against interest forgone.

Question 2

With regard to banking, what is meant by:

(a)   Aggregation

(b)   Maturity transformation

(c)   Risk transformation?

Question 3

Is the following statement true or false?

"Bank overdrafts are repayable on demand"

Question 4

How does a repo market operate?