Cash Management

CASH MANAGEMENT

CASH Includes:

1. Currency and cheques held by the firm

2. Bank Balances

3. Near-cash items such as marketable securities

CASH MANAGEMENT Cash is the most liquid and least productive current

asset

Cash is vital for daily operations

Efficient cash management essential for solvency of a

firm

Sufficient cash balance must be maintained as:

Shortage of cash will disrupt the organisations

operations

Excess cash balance will result in funds remaining

idle, which adversely affects the profitability.

1. Transaction motive

2. Precautionary motive

3. Speculative motive

MOTIVES FOR HOLDING CASH

To carry out the operations of an organisation

To make payments for purchases, salaries, rent, etc

To meet anticipated payments whose timing is not

perfectly matched with cash receipts

Cash balance must be maintained for periods when cash

payments exceed cash receipts.

Conversely for periods when cash receipts exceed cash

payments, the surplus cash must be invested in marketable

securities. These may be encashed in the future to meet

some anticipated payments eg taxes or dividends

1. Transaction Motive

2. Precautionary Motive

Cash is held to meet contingencies in the future.

Is Buffer for unexpected emergencies held due to

uncertainty about prediction of timing and magnitude of

cash flow

Amount depends on

predictability of cash flows

firms ability to borrow at short notice

Held more in marketable securities which are highly

liquid and low risk

Holding of cash for investing in profit-making

opportunities as and when they arise.

Cash is held in Expectation of

Increase in interest rates and fall in security prices

- cash held in anticipation of purchase of securities when

their prices fall so as to benefit from any subsequent

increase in prices

Fall in materials prices

- postponement of present purchases and purchases in

future when price actually falls.

3. Speculative motive

Four Facets of Cash Management

Cash planning

Optimum cash level

Managing the cash flows

Investing surplus cash

Cash Planning

Planning cash inflows and outflows to project cash

surplus or deficit

Involves planning and controlling the use of cash.

Requires Cash Forecasting and Budgeting

Cash budget used to plan for and control cash receipts and

payments.

Cash forecasts are needed to prepare cash budgets.

A summary statement of the firms expected cash

inflows and outflows over a projected time period.

Shows the timing and magnitude of cash receipts and

disbursements and the cash balances over the projected

period.

Functions:

1. To determine operating cash requirements

2. To anticipate and plan short-term financing of these

requirements

3. To manage investment of surplus cash.

Cash Budget

Cash Forecasting

Needed to prepare cash budgets.

May be done on short or long-term basis

Short Term Forecasting Method

(Cash Receipts And Disbursements Method)

A. CASH INFLOWS:

1. Operating Cash Inflows:

Cash sales and collections from customers

Most important cash inflow

Sales forecast is required

2. Non - Operating Cash Inflows:

Sale of old assets and dividend and interest income

Generally small in size.

3. Financial Cash Inflows:

Borrowings and issuance of securities

External financial sources

B. CASH OUTFLOWS

1. Operating Cash Outflows:

Cash purchases, payment of payables, advances to suppliers, wages/ salaries and other operating

expenses.

2. Capital Expenditures:

Purchase of Plant & Machinery etc.

3. Contractual Payments:

Repayment of loan and interest and tax payments, etc.

4. Discretionary Payments:

Ordinary and preference dividend, etc.





The net cash inflow or outflow for each month is determined by combining the forecasts for cash

receipts and payments.

The net balance for each month is determined by combining the opening cash balance and net cash

inflow/outflow. This balance would indicate whether the

firm has excess cash or deficit.

If the firm has a policy of maintaining some minimum cash balance, arrangements must be made to maintain

this minimum balance in periods of deficit. Conversely

any surplus is invested in marketable securities

The following information about Beta Company is given:

The estimated sales for the period January 20X1 through June

20X1 are as follows: Rs.100,000 a month from January through

March and Rs.120,000 a month from April through June.

The sales for November and December of the previous year have

been Rs.100,000 each.

Cash and credit sales are expected to be 20 percent and 80 percent

respectively.

The receivables from credit sales are expected to be collected as

follows: 50 percent after one month and the balance 50 percent after

two months.

Other anticipated receipts are: Rs.5,000 from the sale of a machine

in March and Rs.2000 interest on securities in June.

Illustration

CASH BUDGETING

January February March April May June

1. Sales 100,000 100,000 100,000 120,000 120,000 120,000

2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000

3. Collection of

accounts receivables 80,000 80,000 80,000 80,000 88,000 96,000

4. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000

5. Receipt from

machine sale 5,000

6. Interest 2,000

Total cash

receipts 100,000 100,000 105,000 104,000 112,000 122,000

(3+4+5+6)

CASH BUDGETING

Relevant information for cash payments

Beta Company plans to purchase materials worth Rs.40,000 in January and

February and materials worth Rs.48,000 each month from March through

June. Payments will be made a month after the purchase

A payment of Rs.40000 will be made in January for purchases in the previous

December

Miscellaneous cash purchases of Rs.2000 per month are planned from January

through June

Wage payments will be Rs.15000 per month, January through June

Payments for manufacturing expenses will be Rs.20,000 per month and for

general administrative expenses will be Rs.10,000 per month, January through

June

Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for

June

A machine will be bought in cash for Rs. 50,000 in March

CASH BUDGETING


1. Material purchases 40,000 40,000 48,000 48,000 48,000 48,000

2. Credit material purchases 40,000 40,000 48,000 48,000 48,000 48,000

3. Payment of 40,000 40,000 40,000 48,000 48,000 48,000 accounts payable

4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000 cash purchases

5. Wages 15,000 15,000 15,000 15,000 15,000 15,000

6. Manufacturing exp. 20,000 20,000 20,000 20,000 20,000 20,000

7. General admn. expense 10,000 10,000 10,000 10,000 10,000 10,000

8. Dividend - - - - - 20,000

9. Tax - - - - - 20,000

10. Capital - - 50,000 - - - expenditure Total payments 87,000 87,000 137,000 95,000 95,000 135,000 (3+4+5+6+7+8+9+10)

CASH BUDGETING

Assuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balance

required by the firm is Rs.20,000, the summary cash forecast is given below.


1. Opening cash

balance Rs.22,000

2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000

3. Payments 87,000 87,000 137,000 95,000 95,000 135,000

4. Net cash flow (2 3) 13,000 13,000 (32,000) 9,000 17,000 (13,000)

5. Cumulative net

cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000

6. Opening cash

balance + Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000

7. Minimum cash balance

required 20,000 20,000 20,000 20,000 20,000 20,000

8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000

relation to the minimum cash balance required (6 7)

Optimal Cash Balance

Sufficient Cash balance has to be maintained by a firm so as

to meet its short term obligations as and when they fall due.

Excess cash reduces profitability and insufficient cash

balance reduces liquidity and hinders operations

A trade-off between excess cash and insufficient cash is

required for the determination of optimum Cash Balance.

Models for determining Optimum Cash Balance:

1. Baumols Model

2. Miller - Orr Model

1. Baumols Model

Developed by William. J. Baumol.

Determines a firms optimum cash balance under certainty.

Considers cash management similar to inventory management problem.

Applies the EOQ Model to determine the Optimum Cash

Conversion Size and hence Optimum Cash Balance.

The optimal cash conversion size is the amount of cash that can be obtained by converting securities to cash at minimum cost

considering the conversion costs(transaction costs) and the cost

of holding cash idle (interest foregone cost)

The model minimizes the total of the cash holding costs and the cost of converting marketable securities into cash.

1. Baumols Model

Assumptions:

1. Cash needs can be forecast with certainty.

2. Cash payments occur uniformly over a period of time.

3. The opportunity cost of holding cash (holding cost) is

known and constant over time.

4. Transaction cost i.e. cost of converting securities to cash

is known and constant per transaction irrespective of

transaction size.

Holding Cost:

Is the the opportunity cost of holding cash i.e. the return foregone on marketable securities.

If the opportunity cost is i, then the firms holding cost for maintaining an average cash balance is as follows:

Total holding cost= i (C*/2)

Transaction Cost:

Is the cost of converting marketable securities into cash.

Total number of transactions in a year or a period equals total funds requirement, T, divided by the cash balance (cash

conversion size) C*, i.e. T/C*.

If the Cost per transaction is b, the total transaction cost =

Total conversion cost = b (T/C*)

1. Baumols Model

Total annual cost of the demand of cash will be:

i (C*/2) + b(T/C*) The optimum cash conversion size, C*, (and therefore

optimal cash balance ) is obtained when the total cost is

minimum.

Total Cost

Holding Cost

Transaction

Cost

Cash Balance C*

Co

st

1. Baumols Model

Optimum cash conversion size =

Where, C* = Optimum cash conversion size

b= Cost per transaction

T = Total cash Requirements during the

period/year

i = opportunity cost of holding cash balance

(interest rate per planning period on investment in

marketable securities)

1. Baumols Model

i

bTC

2*

2. Miller-Orr Model

Developed by M.H. Miller and D.Orr.

The limitation of the Baumol model is that it doesnt allow the cash flows to fluctuate.

Firms in practice dont use their cash balance uniformly nor are they able to predict daily cash inflows and outflows.

The Miller-Orr Model overcomes this shortcoming and allows for daily cash flow variations.

It provides for three levels of cash balances:

Upper Limit (UL)

Lower Limit (LL), and

Return Point (RP)

2. Miller-Orr Model

When cash balance hit the UL, the firm must

reduce cash balance by

buying sufficient

marketable securities

such that the cash balance

reaches RP.

If the cash balance hit the LL, the firm must increase

cash balance by selling

sufficient marketable

securities so as to reach

RP.

Cash

Bala

nce

Time

Lower Level

Return Point

Upper Level

Sell Marketable

Securities

Purchase Marketable

Securities

O

The firm determines three levels of cash balances:

1. Lower Limit (LL)

2. Return Point (RP)

3. Upper Limit (UL)

2. Miller-Orr Model

Levels of Cash Balance

The formula for determining the distance between Re-order Point and lower control limits (LL), known as Z is

as follows:

3

2

4

3

i

bZ

Where:

b = fixed cost per order for converting marketable securities into

cash.

i = daily interest rate earned on marketable securities

2 = variance of daily changes in the expected cash balance

2. Miller-Orr Model


2. Miller-Orr Model


1. Lower Limit (LL):

The firm sets the lower control limit (LL) as per its

requirement of maintaining minimum cash balance.

2. Miller-Orr Model


2. Return Point (RP):

RP = LL + Z

LLi

bRP 3

2

4

3

Where:

RP = return point

b = fixed cost per order for converting marketable securities into cash.

I = daily interest rate earned on marketable securities

2 = variance of daily changes in the expected cash balance

LL = the lower control limit

3. Upper Limit (UL): The distance between the Upper

Limit and the Lower Limit is thrice Z.

UL = LL + 3Z

OR

UL = 3RP 2LL

Note: Average Cash Balance = LL + 4/3 Z

2. Miller-Orr Model


FLOAT

FLOAT = Firms available balance - Firms book balance

Available or collected balance: The balance available

in its bank account as shown by bank statement

Book / Ledger balance: The cash balance shown by a

firm in its books.

1. Disbursement float: Created by cheques issued by a firm

2. Collection or deposit float: Created by cheques received by a

firm. It is sum of postal, processing and bank floats.

Net Float is the net of Disbursement float and the Collection

Float.

Positive Net Float means Available balance > Book Balance.

Only Available Balance Matters So Maximise Net Float!

KINDS OF FLOAT

Cheque

mailed

Cheque

received

Cheque

deposited

Cash

available

Postal float Processing /lethargy

float Bank float

Cash flows are managed to maximise net float by:

A. Accelerating cash collections

B. Delaying disbursements

Managing Cash Flows (Cash Collection And

Disbursement)

A. Accelerating cash collections

1. Prompt billing and cash discount

Automation of billing and enclosure of self-addressed envelop

2. Speeding up Collections by reducing collection or deposit

float through following methods:

i. Lock box

ii. Concentration banking or Decentralised Collections

iii. Electronic fund transfer


Disbursement)

Example

A firm uses a continuous billing system that results in an average

daily receipt of Rs 40,00,000. It is contemplating the institution

of concentration banking, instead of the current system of

centralised billing and collection. It is estimated that such a

system would reduce the collection period of accounts receivable

by 2 days.

Concentration banking would cost Rs 75,000 annually and 8 per

cent can be earned by the firm on its investments. It is also found

that a lock-box system could reduce its overall collection time by

four days and could cost annually Rs 1,20,000.

Evaluate and Compare concentration banking and lock-box

systems.

B. Delaying Payments

1. Paying on last date

2. Centralised payments

Increases transit time

Reduction in operating cash requriement

3. Playing the float i.e. disbursement float

The disbursement float is the amount of money tied up in cheques

that have been written but not yet paid due to time lag in issue of

cheque and its presentation to the bank for collection.

Playing the float involves investing the float during the float

period to earn a return or issuing a cheque without having

sufficient cash in bank at time of issue but arranging funds by the

time of presentation


Disbursement)

Criteria For Evaluating Investment Options

Safety

Liquidity/ Marketability

Yield

Maturity

Investment Of Surplus Funds

Fixed deposits with banks

Treasury bills

Money market Mutual fund schemes

Commercial paper

Certificates of deposit

Inter-corporate deposits

Investment Options

Treasury bills (T-bills)

Risk free, Negotiable, and Highly liquid short term

securities issued by the government at a discount to the face

value and repaid at par

Return = maturity value issue price

Sold through fortnightly or monthly auctions by RBI on

behalf of the government for short-term expenditure needs

Kinds: 91-day, 182 day, 364 days - auctioned on fortnightly

basis

Are short-term financial instruments issued by the govt to

enable people to invest their surplus funds while avoiding

default risk

Commercial papers(CPs)

Commercial Papers are short-term, unsecured, negotiable

promissory note issued at a discount to face value by

creditworthy and highly rated companies, Primary Dealers

and Financial Institutions

Unsecured: no collateral

Redeemable at par

Maturity -7 days - one year

Denomination : Rs. 5 lakhs and multiples thereof

Generally issued by cos. to meet working capital

requirements

Certificate of Deposit

Certificates of Deposit are unsecured, negotiable, short-

term tradable time-deposits issued by commercial banks

and FIs

CD is issued in demat form or in material form as a usance

promissory note by FIs and commercial banks acknowledging

the receipt of deposits

Denomination Rs 1 lac and multiples

Maturity 7 days to 1 year ( Banks)

1-3 years for FIs

Typically unsecured

Interest rate depends on amount and time period

Limits for borrower:50% of the Net Owned Funds

Minimum tenor of borrowing: 7 days.

Usually of three types:

Call deposits,

three-month deposits, and

six-month deposits.

Inter-corporate Deposits

A deposit made by one company with another, normally for a

period up to six months

Cash Management

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