Financial Planning and Management in Public Organizations by Alan Walter Steiss and Chukwuemeka O'C Nwagwu

CASH MANAGEMENT

Cash management is the process of maximizing the liquid assets of an organization through the acceleration of receivables and the disciplined control of disbursements. Cash management assures that an organization;s liquid assets are planned, organized, and controlled such that immediate financial obligations are met in a timely manner and temporarily idle funds are invested in safe and profitable securities from which they can be drawn quickly as the need arises.

Impetus for Cash Management

Cash management focuses on revenues as well as expenditures as it seeks to avoid three potential dangers: (1) a liquidity crisis, when an organization has insufficient cash to meet its obligations; (2) the inability to accelerate receivables and deposit them in the organization's accounts; and (3) the failure to invest funds that may not be needed for days, weeks, or months. Temporarily idle cash balances draw no interest and hence, represent a loss of potential revenue.

Problems of cash management are rarely discussed in the literature of public financial administration. Even less attention has been given to the constraints that may impede efforts to maximize returns on the investment of temporarily idle funds. Local governments and other public organizations stand to realize considerable financial benefits if they manage their resource efficiently. Yet, few public organizations have established specific policy guidelines with regard to the management of cash.

While cash management has been a perennial problem for all governments, it became even more urgent and acute in the late 1970s and early 1980s as a result of the high cost of borrowing money. Interest rates soared to unprecedented heights in the late 1970s, reaching as high as 21 percent in 1980. Governments attempted to keep borrowing to the minimum by managing the cash available more efficiently. In the late 1980s and into the 1990s, the huge and still rising federal debt led the federal government to reduce assistance to state and local governments, thereby forcing these governments to explore other options for additional and/or replacement revenues.

The magnitude and severity of the fiscal crisis confronting major cities (New York City, Cleveland, Philadelphia, Washington, D.C., Los Angeles) has eclipsed the problems of smaller units of government. While the fiscal problems of smaller governmental units may not be as dramatic as those of the major urban areas, they are equally as important, as these units of governments--cities, counties, special districts--encounter increasing pressure on available fiscal resources. The literature of financial management has paid only peripheral attention to the fiscal management needs of smaller units of government. These needs will become the basis for a renewed emphasis in cash management in small local governments.

Maximizing Returns on Cash Flows

Most local officials must continuously seek additional funds to provide an increasing array of public services. As the same time, many jurisdictions may be losing significant revenue by not utilizing the techniques of maximizing returns on their cash flows. Numerous constraints frequently are encountered in efforts to maximize the benefits from these idle funds.

Two Types of Decision Costs

When cash is committed to future use, the holder must forfeit income that could be earned through investments in marketable securities. The amount of cash to be held can be determined by balancing two kinds of cost decision:

(1) The opportunity cost of not investing, which increases as the size of the cash balance increases.

(2) The costs of reviewing information and making the decisions required to invest, disinvest, borrow, or repay loans. These costs decrease as the amount of cash balance increases.

The basic problem in the management of cash is how to balance these two types of conflicting costs. The objective is to incur minimum costs, while at the same time holding a minimum cash balance just large enough to reduce the risk of running out of cash to an acceptable level. Beyond that minimum, maintaining idle cash is an expensive practice. Investing $1 million in a 30-day certificate of deposit, at an annual interest rate of 6%, for example, would earn $5,000.

In the private sector, rising interest rates and the profit incentive have spurred vigorous activity to maximize the utilization of cash resources. Businesses have recognized the potential earnings that can accrue from the short-term investment of idle cash. Many private organizations have employees whose sole responsibility is to management the company's cash position.

The opportunity to minimize interest costs should motivate public organizations to initiate more efficient cash management practices. Public funds should be managed no less prudently than private funds.

Emerging Interest in Cash Management in the Public Sector

Interest in cash management in the public sector has emerged only in the past 20 years, spurred by increasing costs of providing services amid decreasing tax resources, high unemployment rates, and inflation. The primary concern of public financial officers in the past had been to hold sufficient amounts of cash to satisfy the financial obligations of their organizations. This attitude began to change, however, in the face of increasing costs of borrowing, increasing yields of marketable securities, and the rapid expansion of activities that require large amounts of working capital. Many public organizations gradually realized the importance of minimizing cash holdings, accelerating cash inflows, and controlling cash outflows.

Although cash management originally developed out of a custodial function, its role today has expanded and become more sophisticated. [1] Thus, the main objectives of a cash management system are (1) to provide for the adequate availability and safekeeping of funds under varied economic conditions and (2) to achieve an organization's financial objective of an adequate return on investments. These objectives may seem to be contradictory: cash that must be available to meet daily financial obligations cannot at the same time be invested in interest-yielding securities.

The ability of local governments to achieve the objectives of cash management is often limited by constraints imposed by state constitutions, local ordinances and by-laws, and even federal laws or regulations. The financial management practices of local government are restricted by laws that establish procedures for the collection of moneys and payment of obligations and regulate the deposit of funds and the purchase of securities.

Elements of Cash Management

Cash management is made up of four basic elements: (1) forecasting, (2) mobilizing and managing the cash flow, (3) maintaining banking relations, and (4) investing surplus cash. Each of these elements must be actively pursued to achieve an effective cash management system. Following an overview of these four elements, the balance of this chapter will focus on cash flow forecasting and cash mobilization techniques. Investment strategies are discussed in some detail in the following chapter.

Forecasting

As applied to cash management practices, forecasting can be defined as the ability to calculate, predict, or plan future events or conditions using current or historical data. In general, forecasts that cover periods of one year or less are considered short-term, and those that extend beyond one year are considered long-term.

Forecasts form the basis for a cash budget, which monitors how much money will be available for investment, when it will become available, and for how long. Thus, a successful investment strategy for any organization depends on with the accuracy and timeliness of its cash budget. Since many receipts and expenditures are predictable, the cash budget should provide a workable schedule of cash flows for a given period of time. A number of constraints, however, may make it difficult to construct and maintain effective cash budgets for governmental and other public organizations.

Revenues and expenditures in public organizations are not always well coordinated. Owing to the large inflow of revenue just prior to the penalty dates on the tax calendar, there are periods during which idle cash balances accumulate. Intergovernmental transfers--local government entitlements from federal and state sources--are also disbursed on a periodic basis and in relatively large amounts. Bonds issued for capital construction normally are sold before the beginning of the project to ensure complete financing in advance. These funds are then disbursed as costs are incurred throughout the period of construction, leaving a cash balance for investment.

There usually is some variance between forecasts and actual cash flow, because all necessary information and variables cannot be incorporated into the forecast model. The ability of management to make decisions and take actions compatible with sound forecasting techniques is a constraint that affect the cash budget. As Hartley has observed, specific management action will be constrained by "circumstances ruling at the time the decision is taken," including "the nature and size of the cash problem, the financial standing of the local government, the economic environment and the ongoing market rate of interest." [2]

Managing the Cash Flow

Cash flow management involves three basic operations: collection, deposits, and disbursements. The techniques used to assemble funds and make them readily available for investment are known as cash mobilization. Organizations must:

(1) Develop policies and procedures to guide each major source of income/revenue.

(2) Establish deposit procedures to handle major revenue processing problems (such as, the semiannual collection of property taxes in local governments) and for each type of revenue and collection location.

(3) Adopt and maintain policies and procedures for each type of expenditure or category of vendor.

Reducing time delays in collecting receivables is an area with great potential for providing additional usable cash The collection of local property taxes and the penalties that may be levied on delinquent accounts are strictly prescribed by state statutes. Although the law requires people to pay their taxes within a predetermined time span, some people deliberately delay payments, particularly if they will not be penalized for doing so. Efforts to mobilize cash will be futile unless taxpayers make prompt payments. This same caveat applies to prompt payments by clients of other public organizations.

The cash flow problem is essentially that of having sufficient resources in current bank deposits to meet cash obligations. All receipts, checks, money orders, and cash should be deposited as soon as possible. Although this may practice may seem obvious, Smith has noted that many organizations to hold these items for a week or more before depositing them. [3] Idle funds, such as checks sitting in safes, cash registers, or desk drawers over the weekend or even overnight, could be earning income for the organization. Techniques to accelerate collections and deposits include:

(1) Lockbox systems involving the use of special post office boxes to intercept payments of accounts receivable and accelerate deposits for cash utilization.

(2) Electronic transfers to provide a quicker, less costly, and more secure means of moving funds than checks or other instruments that have to move through the postal system.

(3) Area concentration banking--a network of depository accounts in local banks into which receivables are paid and accumulated payments are transferred to a number of regional banks which serve as collection centers.

(4) Disbursement procedures focus on methods, policies, and procedures that an organization can employ in paying its bills. n spite of the overwhelming evidence regarding the efficiency and effectiveness of electronic transfers, some local governments prohibit their treasurers from using such transfers to perform investment transactions. [4] This constraint may severely restrict investment opportunities in a rapidly changing money market.

In recent years, keeping a tight rein on bank balances has become one of the most highly touted principles of cash management. Money not needed for operating costs or to meet compensating balances is money unemployed. Hill contends that "cash can be conserved by employing a sound payables system that centralizes the payment of large bills. This allows for careful timing of disbursements, the ability to take offered discounts, and the possible use of drafts rather than cheques." [5] The techniques that organizations have developed to control their cash balances to avoid the buildup of idle cash will be discussed in a subsequent section.

Banking Relations

Maintaining good relations with the financial community--banks, savings and loan associations, investment bankers, commercial paper dealers, and security analysts--is an important part of cash management. Local governments are frequently constrained by state laws in the formation of relations with banking institutions. State laws may determine, for example, the bank or banks with which a local jurisdiction may do business. Banks licensed to operate in the state are preferred, and localities may be further restricted to banks operating in their particular city or county. Total deposits by the local government in each local bank may be legally restricted, based on the bank's capital. Finally, local politics may influence financial management practices in selecting depository institutions and making investments.

Although the idea of "spreading the wealth around" makes good political sense, it makes bad economic sense. From a cash management perspective, using too many local banks makes it difficult to determine how much cash is available for investment purposes at any given point in time. On the other hand, if a jurisdiction "puts all its eggs in one basket," it is likely to receive lower yields on its investments than if it had "shopped around." The choice of one bank for the deposit of the majority of local government funds may be based on tradition or on politics

Shifting business among three or four local banks on an annual or biannual basis is a good political strategy that also simplifies cash management by minimizing the number of open bank accounts. However, competition may be limited, and local banks may not be motivated to offer additional services to the local jurisdiction or to improve existing ones.

Whenever possible, the banks with which a local government does business should be selected through a competitive bid process. The bidding process involves four steps. First, an evaluation must be made of the financial environment to determine the basic requirements of the organization and what it is willing to pay for these services. Next, a request for proposals should be prepared and circulated to competing banks. Third, the proposals submitted should be reviewed in an open manner, making the criteria for selection public. Finally, local officials should select and enter into contractual agreement with the bank or banks that best meet the established criteria. The benefits to be derived from competitive bidding are as follows:

(1) Additional interest earnings from improved yield, resulting in overall increase in amounts available for investment.

(2) Additional services provided for the same amount of bank charges.

(3) Reductions in bank service charges or compensating balances.

(4) Overall increase in efficiency of cash management operations.

Bankers prefer compensating balances to fee payments because deposits are the main source of a bank's loanable funds. The compensating balance is a constraint on the ability of a local government to maximize earnings, however, because banks require a minimum average rather than an absolute minimum balance. [6] This issue is critical, since the average cash balance determined interest revenue, a key factor in cash management profitability.

Compensating balances generally are negotiated and mutually agreed upon by the local jurisdiction and its banks. Prior to these negotiations, local financial executives must come to definite decisions on a number of issues: (1) how much money should be kept in the bank to cover the jurisdiction's operating needs; (2) what types of services are expected from the bank; and (3) how much the locality is will to pay for these services. As Sanders and Kirk point out, compensating balances represent "potential lost revenue that may exceed the amount the jurisdiction might have paid if fees for each service had been levied by the bank." [7]

Banks should provide an analysis of compensating balances periodically. If the jurisdiction determines that its banks' demands for compensating balances have been excessive, it should take appropriate action to renegotiate them downward. On the other hand, if the analysis indicates that the banks are being under-compensated, the jurisdiction should be prepared to leave larger amounts on balance to support the established quality of services.

Investment of Excess Funds

Cash on hand to meet future financial obligations should be invested in short-term securities. A cash budget should provide an estimate of the organization's cash requirements for disbursement by months, weeks, or days. Such an estimate should enable the financial manager to determine what part of the cash balances can be invested. Different investments can be timed to mature when the funds are needed. When the timing is uncertain, funds can be held in securities that can be quickly converted into cash. Longer investment periods offer higher yields but less liquidity.

Since local governments and other public organizations are not profit oriented, they often are encouraged to hold short-term securities which have high liquidity and can be easily converted into cash, either through the market or through maturity. 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, commercial paper, banker acceptances, and repurchase agreements. [8]

Investors should be aware of seven characteristics of securities: (1) yield, (2) maturity, (3) marketability or liquidity, (4) risk, (5) call provisions, (6) the availability of denominations, and (7) taxability. In most cases, the decision to purchase a specific security will be guided by considerations of yield, liquidity, and maturity. Risk usually is a relatively minor factor in local government because state and federal laws restrict the financial officer's ability to engage aggressively in the money market.

Cash Flow Forecasting

A forecast indicates the most likely outcome of a future event based on what is currently known about the circumstances that will influence that event. As Hartley has observed:

In the context of cash management, the ultimate objective of a forecast is to guide appropriate and timely management action toward improved control of the organization's cash flow. A forecast that turns out to be incorrect is not necessarily a "bad" forecast. By the same token, a forecast that turns out to be right is not always a "good" forecast. Rather, a good forecast is one that provides a sound basis for management action as the future unfolds and as events begin to diverge from the forecast. A good forecast provides alternative scenarios and strategies that can be adopted as environmental conditions and organizational needs change.

Forecasting in the Budget Process

The primary objective of cash management is to ensure that sufficient funds are available to meet organizational needs at a minimum cost, including the opportunity cost associated with uninvested funds. This objective calls for:

(1) An accurate cash flow forecast to eliminate the need for (or to minimize the cost of) short-term borrowing.

(2) The efficient collection of receivables from the point of receipt to the place where funds can be invested or spent.

(3) A scheduling of reimbursements to ensure that obligations are paid on time, but not ahead of payment deadlines.

Without a cash budget, a manager cannot obtain a long-term view of cash flow patterns and, therefore, cannot effectively plan future cash requirements and optimal investments.

Actions That Affect the Movement of Cash

Cash flows as a result of management actions regarding receivables and disbursements. Decisions that elicit the flow of cash can be summarized under the following categories: (1) operating decisions; (2) capital expenditure decisions, (3) credit decisions, (4) investment decisions, and (5) financing decisions.

Operating decisions stem from the policies of the organization, such as the creation or elimination of a service unit or department, increases in the charges for services or in the tax rate, changes in the salaries and fringe benefits extended to staff, and so forth. The implementation of such actions will result in adjustments in the inflow and outflow of cash.

Capital expenditure decisions that affect the infrastructure of the organization give rise to the outward flow of cash. An organization's infrastructure involves the construction, repair, and maintenance of fixed, physical assets. Local governments must provide the necessary infrastructure for social and economic development. In this context, Holland defines public infrastructure as "all government capital investment including social investment such as education and health case." [10]

Credit decisions involve the length of time an organization takes to make payments to its vendors for goods and services provided, as well as the length of time a client/customer may take to make payment to the organization without penalty. An increase in supplier credit time is like providing the organization with an interest-free loan. The organization can invest the amount owed in short-term financial assets and earn interest prior to the payment deadline. An increase in the credit period granted to customers/clients, on the other hand, delays the flow of cash into the organization's treasury.

Investment and financing decisions set the flow of funds in motion. Investment decisions result in the use of inactive cash to purchase financial assets or the liberation of funds by the sale of such assets. Financing decisions involve the acquisition of new money by selling bonds, borrowing, or increasing revenues (i.e., by raising user charges, prices, or taxes). It is obvious that cash does not flow of its own accord. Managers are responsible for initiating the flow of cash and must be able to monitor and control the direction of the flows to ensure that their organizations will not encounter cash flow problems.

Rationale for Forecasting

The preparation of a cash budget on a regular and systematic basis increases the confidence of lending institutions in the organization and those who manage it. Any financier or lender would like to know when an organization will need additional funding, for how long, and in what amounts. Answers to these questions, coupled with the availability of relevant data and charts to support the answers, enhance the ability of an organization to raise funds when required.

The cash budget also enables improved use of capital. Forecasting not only spots cash deficiencies, but also indicates if and when cash surpluses are likely to be available for investment in interest-yielding securities. Conversely, when deficits occur, short-term borrowing can be arranged or maturing assets redeemed.

Ill-conceived and premature ventures usually result in serious financial consequences. Systematic forecasts of an organization's cash position, however, should reveal the potential impact on cash flow of such expenditures. This advance warning provides an opportunity to reconsider the expenditures and/or their timing. A cash budget reveals the movement of cash into and out of the treasury. 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.

The prospect of going bankrupt is the most serious threat to the life of any organization. Organizations do not go bankrupt because they have had to liquidate their financial assets. Rather, they go bankrupt because they have cash flow problems. The avoidance of bankruptcy should be sufficient justification for cash forecasts.

Timing is an important element in cash forecasting. Even if all quantities of future cash flows can be estimated correctly, an organization may still be in considerable financial difficulty if the timing of the forecast is flawed. Thus, accurate timing of receipts and expenditures will enhance the capacity of the cash budget to serve the objectives enumerated above.

Types of Forecasts

Broadly speaking, there are two types of forecasts, each serving a distinct purpose. Short-term forecasts usually cover a period of less than one year. If appropriately designed and regularly revised, a short-term forecast can assist in the day-to-day operations of an organization because it is based on a detailed statement of all the accounts that either generate or absorb cash. A short-term forecast highlights the peaks and troughs resulting from the daily, weekly, or monthly operations of the organization.

Long-term forecasts evaluate an organization's financial position over an extended period of time--two, three, or even five years into the future. Unlike more detailed short-term forecasts, a long-term forecast attempts to provide only a rough sketch of an organization's more distant financing requirements. Private firms use long-term forecasts to gauge the impact of proposed acquisitions, mergers, or new product developments on the cash flow position a number of years into the future. Such forecasts may also be used in determining the future cash needs of the organization, especially its working capital requirements. If, for example, an organization is experiencing a serious cash outflow without a corresponding cash inflow, a sound cash forecast should provide a good indication of the rate and duration of this disparity and why it is happening.

The long-term forecast also facilitates the appraisal of proposed capital projects. It shows "not only how much cash the organization will generate to support these projects, it also shows how much financing, if any will be required to complete them." [11] Thus, the extended cash forecast assists in deciding which proposed projects related to the expansion of the organization should be approved, deferred, or abandoned.

The Decision Environment of Government

In the private sector, the corporate hierarchy determines objectives and adopts the strategic plan, which is updated from time to time to reflect changing conditions both inside and outside the organization. In the public sector, however, the plan, or budget, that ultimately emerges is a reflection of a consensus reached and deals struck in extended negotiations among various participating parties. The discipline evident in private-sector expenditure patterns often is lacking in the public sector, making forecasting very difficult.

Forecasting in the public sector should be relatively easy because governmental cash requirements are based on budgeted expenditures, which are finite and known in advance. Government revenues are tax-based and, therefore, estimable

However, the mood of the voters, as interpreted by elected and appointed officials, determines the direction of expenditures (and also receipts). Major expenditure decisions are made by the County Board of Supervisors or City Council. Disbursement authority over major expenditures may also reside with the Board or Council. The finance officer may have little or no control over the timing of the disbursements that must be made. Any attempt to forecast revenues and expenditures can be seriously undermined by the uncertainties and irregularities of the timing of major commitments.

The major argument of those who believe that forecasting can serve only limited objectives is that the world is not static and that the assumptions under which a forecast is developed can change significantly even before the exercise is complete. Revenues are forecast on the assumption that all the variables taken into consideration--such as the general economic climate, prevailing prices, and legislative policies--will remain as they were. They almost certainly will not. Opponents of forecasting also argue that the knowledge and theoretical basis on which to predict what the economy will do in the next five years do not exist. They further argue that a forecast, the stability of which cannot be guaranteed, cannot for the basis for sound future financial planning.

This negative perspective misses a fundamental premise of forecasting. A forecast is an approximation of what will likely occur in the foreseeable future. The objective of forecasting is not to be accurate, but to provide a basis on which to measure the differences between actual events and the plan. In this way, the nature and extent of corrective actions can be more clearly defined. As Smith points out, a forecast is: "used to measure the gap between what will probably happen, leaving things alone, and what we want to happen. It gives a measure of the difference, which then forms the basis for developing different strategies. . . to eliminate the difference. [12] Once this point is understood and accepted, the utility of forecasting as a tool of cash management can be more fully appreciated.

The notion that forecasting is impossible in the public sector is furthermost from the truth. A survey of county governments indicates that 60 percent of the responding jurisdictions regularly attempt some form of forecast of their revenues and expenditures and use these forecasts as the basis for financial decision making. [13]

Wildavsky asserts that the best predictor of next year's budget is this year's budget. "Those in government operate in a world they never made, which is only partially subject to their ministrations. Commitments of the past make up the largest part of the budget, and it is either legally or politically impossible to alter them drastically." [14]

In order to estimate revenues, the manager should be knowledgeable about the specific historical characteristics and collection patterns of each revenue source. The development of a three-year "historical detail profile" is necessary to obtain a trend about the behavior of the various revenue sources. [15] This profile should include when revenue was received, the amounts received at those times, significant deviations in collection patterns, and relevant explanatory information.

The development of a historical profile may not be necessary for some revenue sources--for example, intergovernmental transfers and other revenues that are received according to established contracts and agreements. Revenues such as property taxes and user fees are received according to well-established patterns but the amounts collected during each specific time period may vary significantly from year to year. Consequently, a historical detail profile would facilitate more accurate projections of these revenues.

Summary

Although the environments of public organizations are different from those of private firms, these differences should not preclude the application of cash management models in the public sector. The inability of local governments to develop and install efficient cash budgeting systems is a major constraint, limiting their capacity to maximize the returns on the investment of otherwise inactive cash. Unless local governments can develop reliable estimates of their cash flow positions, enabling them to identify how much cash will become available, they will not be in a position to maximize the returns on whatever financial assets they are able to purchase.

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