Miller Orr Model_Setting Optimal Cash Balance_Working Capital Management_New_Latest 21

Summary

In this informative tutorial on working capital management, Peter explains the importance of managing current assets and liabilities to maintain liquidity in an organization. He emphasizes the optimal cash balance needed for day-to-day operations, introducing the Miller-Or model as a method for determining this balance. The model, which operates under the assumption of normally distributed daily cash flows, helps set target cash balances and limits for cash management. Through a practical example involving Printex Company, Peter illustrates how to calculate target cash balance, upper limit, average cash balance, and spread, ensuring organizations can effectively manage their cash resources.

Takeaways

• 😀 Working capital management involves managing an organization's current assets and liabilities to ensure adequate liquidity.
• 💡 A recommended ratio for current assets to current liabilities is 2:1, indicating that current assets should be twice the current liabilities.
• 💰 Setting an optimal cash balance is crucial for daily operations; holding excess cash can be inefficient.
• 📊 The Miller-Orr model helps determine an optimal cash balance based on the probabilistic distribution of daily cash flows.
• 📈 The Miller-Orr model assumes that daily net cash flows are normally distributed, meaning cash inflows and outflows fluctuate around a target amount.
• 🔒 In the model, a target cash balance is established along with upper and lower limits to guide cash management decisions.
• 📝 To calculate the target cash balance (Z), the formula involves transaction costs, variance of cash flows, and opportunity cost.
• 🏦 The upper limit (H) indicates the maximum cash amount an organization can hold before needing to invest excess in marketable securities.
• 📉 The average cash balance represents the mean amount of cash maintained, which should ideally support operational needs.
• 💬 Viewers are encouraged to engage with the tutorial by subscribing, liking, and commenting to support the channel and learn more about finance and accounting.

Q & A

What is working capital management?

Working capital management refers to managing the current assets and current liabilities of an organization to ensure it has sufficient liquidity to meet its obligations and operational needs.

What is the recommended ratio of current assets to current liabilities?

The recommended ratio of current assets to current liabilities is 2:1, meaning that current assets should be twice the amount of current liabilities.

Why is maintaining an optimal cash balance important?

Maintaining an optimal cash balance is critical to ensure that the organization can cover its day-to-day expenses without holding excessive cash that could be invested elsewhere for returns.

What are the two models discussed for determining optimal cash balance?

The two models discussed for determining optimal cash balance are the Miller-Orr model and the Moles model.

What does the Miller-Orr model assume about daily cash flows?

The Miller-Orr model assumes that the distribution of daily net cash flows is approximately normal, allowing for variability in cash inflows and outflows.

What are the components of the cash balance graph in the Miller-Orr model?

In the Miller-Orr model, the cash balance graph includes a target cash balance (Z), an upper limit (H), and a lower limit (L). The organization must adjust its cash balance between these limits.

How is the target cash balance calculated in the Miller-Orr model?

The target cash balance (Z) is calculated using the formula: Z = (3 * B * Variance) / (4 * I) raised to the power of 1/3, plus L, where B is the fixed transaction cost, Variance is the variance of cash flows, I is the opportunity cost, and L is the lower limit.

What is the significance of the lower limit (L) in cash management?

The lower limit (L) represents the minimum cash balance an organization should maintain. If cash falls below this amount, the organization must take action, such as selling marketable securities, to restore its cash position.

How do you calculate the spread between the upper and lower limits?

The spread is calculated by subtracting the lower limit (L) from the upper limit (H). It indicates the range within which the cash balance can fluctuate.

What actions does an organization take if its cash balance exceeds the upper limit?

If the cash balance exceeds the upper limit, the organization should invest the excess cash in short-term marketable securities to bring the balance back down to the target cash balance.