Question

Effective cash flow management is the first step in managing interest rate and currency risk. Using examples, explain the stages involved in cash flow management

Answer 1

Yes, the effective cash flow management is the first step in managing interest rate and currency risk. Let's understand managing interest rate and currency risk by example:

Managing Interest Rate:

This is mainly used in bond purchase. Example, if you have buy 2% fixed interest bearing 10 years bond of $10,000. This bond pays $200 per year till maturity. Here if investor continues holding till maturity he may lose the opportunity to earn higher interest rate. May be another bond which pays 2.5%.

Currency Risk:

When you do business out of country and deals in different currency then you are exposed to currency Risk. Example, I buy a machinery work 100,000 Euro then I prefer to enter into a forward contract which fixes the exchange rate for the payment of purchase which reduces my risk of change in exchange rate and effect on profitability.

Stages involved in Cash flow management:

Mainly three steps involve in calculating cash flow :

Cash flow from Operations: which includes cash inflow from operating activity like customer invoices and cash out flow like wages and salaries.

Cash flow from Investing: Here cash inflow and cash outflow indicated any purchase or sale of equipment.

Cash flow from Financing: which includes payments for any loan, dividend payment. Includes cash inflow of issue of new equity shares.

Net change in Cash balance : which indicates after considering above three what will be the change in cash balance.

Below is the example of Cash flow of XYZ Inc.

Cash Flow From Operations
Receipts	US $
Customer Invoices	$100,000
Other	$5,000
Disbursements
Employee Salaries	($50,000)
Suppliers	($20,000)
Other	($5,000)
Net Cash Flow From Operations	$30,000
Cash Flow From Investments
Equipment and Software Purchases	($10,000)
Net Cash Flow From Investments	($10,000)
Cash Flow From Financing
Loan Payments	($5,000)
Shareholder Dividends	($2,000)
Net Cash Flow From Financing	($7,000)
Net Change in Cash Balance	$13,000

From the above Cash flow analysis. Operating cash flow helps to decide Collection period from customer and payment period to vendors can and help to do the necessary changes to make better cash flow position.

Investing stage also includes purchase and sale of equipment. Here if equipment is purchased from outside the country then currency risk should be considering and should entered in to the forward rate contract to avoid any major changes in exchange rate.

Financing stage includes buying of bonds whereas explained above risk of interest rate change should be there.