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CASH AND INVENTORY MANAGEMENT

In late 1999 citizens and corporations in the United States held nearly $1,100 billion in cash. This included about $500 billion of currency with the balance held in demand deposits (checking accounts) with commercial banks. Cash pays no interest. Why, then, do sensible people hold it? Why, for example, don`t you take all your cash and invest it in interest-bearing securities? The answer is that cash gives you more liquidity than securities. By this we mean that you can use it to buy things. It is hard enough getting New York cab drivers to give you change for a $20 bill, but try asking them to split a Treasury bill.

Of course, rational investors will not hold an asset like cash unless it provides the same benefit on the margin as other assets such as Treasury bills. The benefit from holding Treasury bills is the interest that you receive; the benefit from holding cash is that it gives you a convenient store of liquidity. When you have only a small proportion of your assets in cash, a little extra liquidity can be extremely useful; when you have a substantial holding, any additional liquidity is not worth much. Therefore, as a financial manager you want to hold cash balances up to the point where the value of any additional liquidity is equal to the value of the interest forgone.

Cash is simply a raw material that companies need to carry on production. As we will explain later, the financial manager`s decision to stock up on cash is in many ways similar to the production manager`s decision to stock up on inventories of raw materials. We will therefore look at the general problem of managing inventories and then show how this helps us to understand how much cash you should hold.

But first you need to learn about the mechanics of cash collection and disbursement. This may seem a rather humdrum topic but you will find that it involves some interesting and important decisions.

After studying this material you should be able to

_ Measure float and explain why it arises and how it can be controlled.

_ Calculate the value of changes in float.

_ Understand the costs and benefits of holding inventories.

_ Cite the costs and benefits of holding cash.

_ Explain why an understanding of inventory management can be useful for cash management.