Short term financing refers to the financing method that uses funds whose repayment or maturity period lies between one day and one calendar year. Short term financing methods fund projects of short term nature (Seidner, 1989, p 7). They are also suitable in cases where a firm is experiencing shortages in working capital. There are several sources of short term finance. These include commercial papers, trade credits, debt factoring, bank credit and invoice discounting. Others are accruals, acceptance credits and accommodation finance.
Having acquired the cash, there is yet another challenging responsibility of managing it. There are several cash management methods. Examples of cash management techniques include monitoring the daily cash position of a firm, controlling balances on deposit, moving funds as required, and managing banking relationships among others. This essay will focus on the Baumol’s model, otherwise referred to as the optimal cash model.
Cash Management Methods
First is the monitoring of the daily cash position of a firm. This helps to determine whether there is any surplus or shortage of funds in a firm. In case of a shortage, arrangement can be made to acquire more funds, while surplus funds will require making more investments. Secondly, it is important to control balances on deposit in order to guard against unnecessary overdrafts. This is also important as it ensures the firm compensates the bank for cash management services (Adam & Harrison, 2001, p14).
Another important cash management method is moving funds as required. This may happen between several accounts and in several places. This also checks fund shortages and surpluses so that appropriate action can be taken. Managing short term borrowing and investing is another crucial exercise in cash management.
The Baumol’s Cash Model
William J. Baumol developed the Baumol’s Cash model. The model focuses on how firms attempt to minimize the sum of the holding cash and the cost of converting marketable securities to cash. Essentially, the model strives to minimize the total cost of a fund or anything else. Nevertheless, the model makes various assumptions. First, Baumol assumes that a firm is able to forecast the extent of its cash needs with a reliable degree of certainty. Another critical assumption is that the firm is likely to incur the same transaction cost whenever it converts securities into cash.
Another important assumption present in the Baumol’s model is that the opportunity cost of holding cash is known and that it remains constant over a period of time. This makes it possible to optimize the use of finances in a firm. The ability of the firm’s cash payments to remain uniform over a period of time is another assumption characterizing the Baumol’s model. The Baumol’s model can be illustrated as follows.
A firm will usually sell its securities in order to raise its cash balance (Mason Gaffney Notes, 1987, p1). In order to maintain the cash balance, a firm incurs a cost known as the holding cost. The holding cost also embodies the opportunity cost since it is inevitable on marketable securities. However, the cash balance will not be unaffected for long since the firm has to fund its operations in order to remain solvent. Consequently, the firm will begin to spend its cash balance. The cash balance then begins to reduce and may even run out. When this happens, the firm will against resort to selling its marketable securities.
As a firm sells its marketable securities, it incurs another cost. This cost is known as the transaction cost. Every year, the total number of transactions made equals the total funds required by the firm divided by the cash balance the firm has acquired.
As the firm sustains its operations, the demand for cash increases. The increase in the demand for cash results into a corresponding increase in the holding cost. However, the transaction cost will decline due to the reducing number of transactions. This effectively establishes a relationship between the holding cost and the transaction cost. The optimum cash balance can then be obtained. An increase in the transaction cost and the total funds needed by a business will inevitably raise the optimum cash balance. On the other hand, an increase in opportunity cost will reduce the optimum cash balance of a firm.
Two strategies may be employed in order to manage the cash balance of a given firm. These are the two transaction strategy and the three transaction strategy. In the two transaction strategy, cash inflow is divided into two equal parts. One part is put into investment while the other is deposited into the disbursement account for use. The firm will pay out disbursements from the disbursement account during the first half of the period. The funds will run out before the expiry of the period. The firm can simply sell the investments and pay the disbursements.
The three transactional strategy requires a firm to invest two-thirds of the cash inflow realized. The disbursement account only receives the remaining one third of the cash inflow. The amount in the disbursement account will cover only one third of the period. The firm can the disinvest one half of the money in the investment account. Essentially, this strategy requires making one investment and two disinvestment transactions.
The Baumol model has various short-comings. To begin with, it does not make room for any fluctuations in cash flows. It relies on the assumption that factors will remain constant for a given period of time. This may not be necessarily the case. Secondly, the model does not put overdrafts into consideration, yet a business may decide to go for overdrafts in order to address a shortage of funds. There may be uncertainties in cash flow patterns in future, as usually happens; however, the Baumol’s model ignores this factor.
It is also primarily concerned with oligopolistic firms such as those found in retails and airline and retail industries, but not fully compatible with other types of market structure such as perfect competition, monopoly and Monopolistic Competition (McNutt, 2005, p23). Secondly, the profit is considered exogenous to the model. Thirdly, while accepting the presence of competition and presume interdependence, it ignores the behavior of rival firms; and fourth, managers have no utility trade-off between profits and sales, up to the profit constraints the firm is concerned only with profit and after the constraints is met, the only concern is with sales.
Essentially, short term financing is suitable for firms that are experiencing shortages in working capital. However, it is important for firms to manage the funds acquired appropriately. The Baumol’s model can help firms take control of their funds and use them wisely; however, it is important to address the model’s short-comings. Nevertheless, Baumol’s model is a useful tool for optimizing the use of funds in a business.