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III. CASH MANAGEMENT AND INVESTMENT STRATEGIES
Cash management is the process of maximizing the liquid assets through the acceleration of receivables and the disciplined control of disbursements.
The amount of cash to be held can be determined by balancing two kinds of cost decisions:
(1) Opportunity cost of not investing, which increases as cash balances increase.
(2) Information costs involved in making the decisions to invest, disinvest, borrow, or repay loans, which decrease as the amount of cash balance increases.
Elements of Cash Management
Cash management is made up of four elements: (1) forecasting, (2) mobilizing and managing the cash flow, (3) maintaining banking relations, and (4) investing surplus cash.
Forecasting can be defined as the ability to calculate, predict, or plan future events or conditions using current or historical data.
A cash budget monitors how much money will be available for investment, when it will become available, and for how long.
Cash mobilization involves techniques used to assemble funds and make them readily available for investment
Maintaining good relations with banks, savings and loan associations, investment bankers, commercial paper dealers, and security analysts is an important part of cash management.
Bankers prefer compensating balances to fee payments because deposits are the main source of a bank's loanable funds.
A cash budget should provide an estimate of the organization's cash requirements for disburse-ment by months, weeks, or days.
The most attractive instruments are securities supported by the full faith and credit of the federal government.
Other relatively risk-free securities are: time deposits, time certificates of deposit (CDs), commercial paper, banker acceptances, and repurchase agreements.
Cash Flow Forecasting
To ensure that sufficient funds are available to meet organizational needs at a minimum cost:
(1) Cash flow forecasts must be made to minimize the cost of short-term borrowing.
(2) Receivables must be collected efficiently from point of receipt to the place where funds can be invested or spent.
(3) Reimbursements must be scheduled to ensure that obligations are paid on time, but not ahead of payment deadlines.
Management decisions that elicit the flow of cash include:
(1) Operating decisions stem from the policies of the organization, e.g., creation or elimination of a service unit or department, increases in the tax rate or charges for services, changes in the salaries and fringe benefits extended to staff.
(2) Capital expenditure decisions involve the construction, repair, and maintenance of fixed, physical assets.
(3) Credit decisions involve the length of time to make payments to vendors, as well as the length of time clients/customers take to make payment without penalty.
(4) Investment decisions result in use of inactive cash to purchase assets or liberation of funds by the sale of such assets.
(5) Financing decisions involve the acquisition of new money by selling bonds, borrowing, or increasing revenues (as by raising taxes, user charges, or prices).
An astute manager uses a cash budget to identify early signs of an impending cash problem and to indicate appropriate steps to avert the problem.
Forecasting provides a basis on which to measure the differences between actual events and the plan, so that the nature and extent of corrective actions can be more clearly defined.
(1) Short-term forecasts, usually covering a period of less than one year, assist in day-to-day operations by highlighting daily, weekly, or monthly peaks and troughs.
(2) Long-term forecasts gauge the impact on the cash flow position of new services/ products, proposed acquisitions/investments and determine future cash needs, especially working capital requirements.
Local governments must develop reliable estimates of their cash flow positions to take full advantage of the securities market and to maximize the returns on whatever financial assets they are able to purchase.
Cash mobilization involves: (1) acceleration of receivables and (2) control of disbursements.
The flow and availability of cash to the organization can be expedited by collection systems that provide for advance billing and payment on or before receipt of goods and services.
Techniques used to accelerate receipts include:
(1) Lockbox services involve the use of special post office boxes to intercept payments and accelerate deposits.
(2) A preauthorized check (PAC) is a signatureless demand instrument used to accelerate the collection of fixed payment types of obligations.
(3) Concentration banking mobilizes funds from decentralized receiving locations into a central cash pool, enabling the cash manager to monitor only a few cash pools, thereby facilitating better cash control.
Disbursements are the outflow of funds in the form of checks issued and cash payments made.
Delaying cash outflows enables an organization to optimize earnings on available funds.
(1) Centralize, to the extent practical, the management of an organization's payables, particularly those involving large dollar amounts.
(2) Establish administrative limits on the amount of disbursements particular organizational units are authorized to make within specified time periods.
Consolidation of accounts reduces compensating balance, provides better control over the timing of payments, increases the effective use of surplus cash, and permits the streamlining of banking relations.
Zero balance accounts are concentration accounts that are "zeroed out" at the end of each banking day, thereby (1) eliminating the need to maintain excess amounts in disbursement accounts; (2) relieving the cash manager of the burden of estimating when checks will be presented for payment; and (3) permitting the pooling of resources for investment purposes.
Cash management must be artfully blended with the need to maintain good public relations with the vendors that serve the jurisdiction.
Revenue Enhancement Initiatives
Tax diversification is difficult for local governments because, in most cases, it is not within their authority to determine their sources of revenue.
Amnesty programs for delinquent taxes, coupled with enforcement of stiffer penalties for tax evasion have been enacted to provide inducements for the recovery of back taxes.
Compensatory payment programs are designed to reimburse local governments for revenues lost because of tax-exempt provisions attached to properties and for cost of providing services.
Service charges promote revenue stability by diversifying local revenue sources and by reaching beneficiaries of local services who would otherwise escape taxation.
Tax exportation is the shifting of the local revenue burden to non-residents through such measures as taxes on hotel, motel, and restaurant bills, entertainment taxes, commuter taxes, airport taxes, and taxes on businesses that sell their products or services to customers outside the taxing jurisdictions.
Reciprocity involves a mutual exchange of enforcement and/or collection responsibilities between jurisdictions.
Gambling and lotteries offer cash-strapped state and local governments the prospect of raising significant revenues without increases taxes.
Fiscal note legislation requires independent cost estimates of the fiscal impact on localities of mandated costs.
Local governments have the option of commercializing services which previously were rendered free of charge.
Cash flow projections should enable the fiscal manager to arrive at reasonable predictions as to how much money will be available to invest and for how long.
Public Investment Criteria
The principal criteria considered in selecting a specific security include:
o Safety is accorded the highest priority by most public officials
o Liquidity involves managing investments so that cash will be available when needed.
o Yield, the ultimate measure of successful fiscal management, is conditioned by interest rates, minimum investment requirements, and the maturity dates of investments.
o Marketability varies among money market instruments, depending on the price stability of the instrument and on the extent of the secondary trading market available to it.
o Risk characteristics of securities must be understood before decisions are made about which specific instruments to purchase.
o Price stability of investments underlines the desire to avoid financial loss in the event of an unexpected cash shortage.
The maturities of the various securities and how these would affect the portfolio mix must be understood before a fiscal manager decides to invest in them.
In general, securities with little risk, high liquidity, and short maturities also have low yields; for an investment to provide a high yield, the other criteria must be compromised.
Many state legislatures restrict the investments of local governments to securities that are collateralized or backed by the United States government.
Types of Securities
Local governments and other public organizations often hold short-term securities that can be readily converted into cash either through the market or through maturity.
U.S. Treasury bills (T-bills) represent an obligation of the federal government to pay a fixed sum of money after a specified period of time from date of issue.
T-bills have no default risk and can be sold quickly for relatively predictable prices in the secondary market.
Zero Coupon Treasury securities represent ownership of interest or principal payments on United States notes or bonds purchased at a discount of 20% to 90% off the $1,000 face value.
Certificates of deposit (CD) are receipts for funds that have been deposited in a commercial bank for an agreed upon period of time.
o The owner of the CD receives both principal and interest on the maturity date.
o CDs are sold according to specified maturity periods, ranging from 14 to 180 days.
Two types of CDs: (1) negotiable, which the original investor can sell to another party on the secondary market; and (2) non-negotiable, which must be retained by the original investor until maturity.
Federal agency securities are issued by government-sponsored, privately-owned agencies established to implement federal policies and include Federal Farm Credit bonds, Federal Home Loan Bank bonds and discount notes, and Federal National Mortgage Association bonds.
Repurchase agreement are contracts between two parties whereby one party sells an instrument (e.g., T-bill) to the other and agrees to buy it back at a later date at a specified higher price.
Two types of repurchase agreements: (1) fixed--a specific interest rate and maturity period are established at the outset and a penalty levied if liquidated prior to maturity; and (2) open--agreement may be liquidated at any time, with the interest rate dependent on the duration of the transaction.
Banker's acceptances, usually created in conjunction with foreign trade transactions, are time drafts negotiated by commercial banks to finance the shipment or storage of goods.
o The bank guarantees to honor the draft on the due date and sells the draft at a discount to an importer.
o On the due date (typically ninety days after issue), the bank honors the draft for the full face value and debits the account of the issuing company.
Commercial paper includes promissory notes of finance corporations or industrial firms which offer higher yields than T-bills.
o Liquidity is low, as secondary trading market does not exists for commercial paper, and as a result of the higher default risks, many states have restrictions against investment by local governments in commercial paper.
o Local governments use commercial paper to (1) meet cash management needs, (2) finance equipment, to provide interim construction financing for capital projects, and to provide loans to business entities.
Derivative securities derive their value from some form of investment, such as Treasury bonds, corporate stocks and bonds, foreign currencies, or commodities contracts.
o Derivatives offer higher yields which makes them attractive at times when short-term interest rates are low.
o Like many rapidly rising investment schemes, the fall can be even more rapid, and for unsuspecting municipal governments, the consequences can be devastating.
Arbitrage occurs when a jurisdiction issues bonds at one rate of interest and invests the proceeds at a higher rate of interest; the resulting gain is referred to as arbitrage earnings.
o Advantages: Governments can make money by investing bond proceeds at higher interest rates than the interest rate on the bonds; however, the arbitrage earnings on tax-exempt bonds are constrained by federal tax laws.
o Disadvantages: Arbitrage earnings that exceed limits imposed by federal regulations must be rebated to the federal government; failure to adhere to federal provisions can, in certain circumstances, cause municipal bonds to lose their tax-exempt status.
The fund manager should possess both formal education and releated experience in investment banking, financial counseling, or related fields.
o Fund managers are expected to handle public funds in a responsible, generally conservative, manner so as to minimize the likelihood of loss of principal.
o A fund manager may be held accountable, however, if the earnings on the invested funds do not achieve their maximum potential.
The fundamental objective of cash management is to maximize yield and minimize risk.
o Cash flow projections should be made to determine the availability of funds for investment under various economic conditions.
o The fund manager should investigate the investment instruments available in the market, determine their relative yields for the maturities required, and evaluate the associated risks.
It is important to design an investment portfolio whereby each security will mature close to the time when the money invested will be needed.
Constraints on Public Investments
Local government investments are regulated by state statutes presumed to reflect public policy.
Local jurisdictions impose additional limitations on their investments to mitigate risk, to diversify investment holdings, and to avoid weak financial institutions.
Banks are required to pledge securities as collateral to secure public investments, the costs of which usually are passed on to the public entity in the form of reduced rates of return.
State-managed investment pools resemble money market mutual funds in their portfolio composition and provide professional management, diversification, and money market rates of return which minimizes the risk to smaller jurisdictions.
Summary and Conclusions
Primary benefits of an investment strategy must be measured in terms of the increased interest earned through the investment of temporarily idle cash.
o Yield, or return on investment, is the paramount criterion for measuring the success or failure of an investment strategy.
o Liquidity can be built into an investment strategy through careful planning and structuring of the portfolio mix.
State laws protect public funds by: (1) limiting banks with which local governments can do business, (2) determining the amounts that can be left on deposit in each bank, and (3) requiring collateral for uninsured funds.
Local governments confront (1) the need to expand revenues if public demands are to be met, (2) already heavily burdened taxpayers, and (3) narrow restrictions on their ability to borrow to finance public expenditures.
The investment portfolio is a source of additional revenue that does not involve increased taxation or additional debt.
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