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Cash management

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Introduction Cash management is one of the key areas of working

capital management.

Apart from the fact that it is the most liquid currentasset, cash is the common denominator to which all

current assets can be reduced because the othermajor liquid asset, that is, receivables and inventoryget eventually converted into cash.

This underlines the significance of cashmanagement.

Cash is the ready currency to which all liquid assetscan be reduced.

Near cash implies marketable securities viewed theway as cash because of their high liquidity.

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Transaction motive An important reason for maintaining cash balances is

the transaction motive.

This refers to holding of cash to meet routine cashrequirements to finance the transaction which a firmcarries on in the ordinary course of business.

For example, cash payment have to be made forpurchases, wages, operating expenses, financialcharges like interest, taxes, dividends and so on.

If the receipt of cash and its disbursements couldexactly coincide in the normal course of operations, a

firm would not need cash for transaction purposes.

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Precautionary motives In addition to the non-synchronization of anticipated

cash inflows and outflows in the ordinary course ofbusiness, a firm may have to pay cash for purposewhich cannot be predicted or anticipated.

The unexpected cash need at short notice may be the

result of: Floods, strike and failure of important customers;

Bills may be presented for settlement earlier thanexpected.

Unexpected slow down in collection of accounts

receivable Cancellation of some orders for good as the customer

is not satisfied

And sharp increase in cost of raw materials

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Contd The cash balance held in reserve for such random

and unforeseen fluctuations in cash flow are called

precautionary balances.

Thus precautionary cash balance serves to provide a

cushion to meet unexpected contingencies. Such cash balance are usually held in the form of

marketable securities so that they earn a return.

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Speculative motives It refers to the desire of a firm to take advantage of

opportunities which presents themselves at

unexpected moments and which are typically outside

the normal course of business.

The speculative motive represents a positive andaggressive approach

Firms aim to exploit profitable opportunities and keep

cash in reserve to do so.

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Contd The speculative motive helps to take advantage of :

An opportunity to purchase raw materials at a

reduced price on payment of immediate cash

A chance to speculate on interest rate movements by

buying securities when interest rates are expected todecline.

Delay purchases of raw materials on the anticipation

of decline in prices

Make purchases at favorable prices

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Compensating motives Yet another motive to hold cash balances is to

compensate banks for providing certain services andloans.

Banks provide a variety of services to business firms,such as clearance of cheque, supply of creditinformation, transfer of funds, and so on.

While for some of these services bank charges acommission or fees, for other they seek indirectcompensation.

Usually clients are required to maintain a minimumbalance of cash at the bank.

Since this balance cannot be utilized by the firms fortransaction purposes, the banks themselves can usethe amount to earn a return. Such balances arecompensating balancesbhushan8

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Contd

The compensating cash balances can take eitherof two forms

(i) an absolute minimum, say, Rs 5 lakhs below

which the actual bank balance will never fall

(ii) a minimum average balance, say, Rs 5 lakh

over the month

Of the four primary motives of holding cashbalances the two most important are the

transaction motives and compensation motives.

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Objectives of cash management

Meeting payment schedules

Minimizing funds committed to cash balance.

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Factors determining cash needs Synchronization of cash flows Short costs

(i) transaction costs

(ii) borrowing costs

(iii) loss of cash-discount

(iv) cost associated with deterioration of the creditrating

(v) penalty rates

Excess cash balance cost

Procurement and management

Uncertainty and cash management

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Baumol model The Baumol model of cash management provides a

formal approach for determining a firms optimumcash balance under certainty.

It considers cash management similar to an inventorymanagement problem.

The purpose of this model is to determine theminimum cost amount of cash that a financialmanager can obtain by converting securities to cash,considering the cost of conversion and counter-

balancing cost of keeping idle cash balances whichotherwise could have been invested in marketablesecurities

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Contd The total cost associated with cash management,

according to this model has two elements:

(i) cost of converting marketable securities into cash

and

(ii) the lost opportunity cost.

The baumols model makes the following

assumptions:

The firm is able to forecast its cash needs with

certainty.

The firms cash payments occur uniformly over a

period of time.

The opportunity cost of holding cash is known and it

does not change over time.bhushan13

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Contd Let us assume that the firm sells securities and starts

with a cash balance of C rupees. As the firm spendscash, its cash balance decreases steadily andreaches to zero. The firm replenishes its cash balanceto C rupees by selling marketable securities.

This pattern continues over time. Since the cashbalance decreases steadily the average cash balancewill be :

C/2.

This pattern is shown below

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Contd

Cash balance

Time

Average

C

C/2

T1 T2 T30

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Contd

The firm incurs a holding cost for keeping thecash balance. It is an opportunity cost; that is

the return foregone on the marketable

securities. If the opportunity cost is i, then the

firms holding cost for maintaining an average

cash balance is as follows:

Holding cost or opportunity cost = i(C/2)

Where i= interest rate that could have beenearned

C/2= the average cash balance that is, the

beginning cash (C) plus the ending cash

balance of the period (zero) divided by 2bhushan16

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Contd The firm incurs a transaction cost whenever it

converts its marketable securities to cash.Total number of transactions during the yearwill be total funds requirements, T, divided by

the cash balance, C, i.e. T/C. the pertransaction cost is assumed to be constant. Ifper transaction cost is b then total transactioncost will be:

transaction cost or total conversion cost perperiod = b(T/C)

Where b= cost per conversion

T= total transaction cash needs for the period

C= value of marketable securities sold at eachbhushan17

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Contd

The total annual cost of demand for cash willcomprise of total conversion cost plus

opportunity cost symbolically it can be

expressed as

i (C/2) +(b)(T/C)

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Contd

To minimize the cost, therefore, the modelattempts to determine the conversion amount

that is the cash withdrawal which costs the

least. The optimum cash balance is obtained

when the total cost is minimum

C= 2bt

i

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Contd

Cash Balance

Annualcost

Slope = 0

Minimumtotal cost

Total Cost

Transaction Cost =

Tb

C

Opportunity Cost =

iC

2

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Miller-Orr model

The limitation of boumol model is that it dose notallow the cash flow to fluctuate. Firm in practice

do not use their cash balance uniformly nor they

are able to predict daily cash inflows and

outflows. The miller Orr model overcomes this

shortcomings and allows for daily cash flow

variation .

Miller Orr assumes that the changes in cash

balance over a given period are random in size

The miller Orr model provides for two control

limits the upper control limit and lower control limitas well as return ointbhushan21

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Time

The Miller - Orr Model

Lower Limit

Upper Limit

Z orReturn poin

Sell Securities

Buy SecuritiesUL

LL

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Contd

If the firms cash flows fluctuate randomly and hitthe upper limit, then it buys sufficient marketable

securities to come back to the normal level of

cash(the return point ) similarly when the firms

cash flow wander and hit the lower limit it sellssufficient marketable securities to bring the cash

level back to the normal level.

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Contd

While the value of lower control limit (LL) is set bythe management based on what it considers to

be the minimum below which the cash balance

should not fall, the values of RP and UL have

been derived by miller Orr with the view tominimizing the total ordering and holding costs.

The following are the results of the analysis

RP =3 3b(s.d)2 + LL

4I

UL = 3RP-2LL

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Control of cash collection and

disbursement.

The strategic aspect of efficient cashmanagement approach are:

speedy collection of accounts receivables and

delaying the payments on accounts payable.

Speedy cash collections: in managing cash

efficiently, the cash inflow process can be

accelerated through systematic planning and

refined techniques. There are two broadapproaches to do this. In the first place the

customer should be encouraged to pay as quickly

as possible. Secondly, the payment from

customer should be converted into cash withoutan dela .bhushan25

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Prompt payment by customer

One way to ensure prompt payment by customeris prompt bi l ling. What the customer has to pay

and the period of payment should be notified

accuretly and in advance. The use of mechanical

devices for billing along with the enclosure of aself-addressed return envelope will speed up

payment by customers.

Another, and more important, technique to

encourage prompt payment by customers, is thepractice of cash discounts.

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Early conversion of payments into

cash.

Once the customer makes the payment by writing a chequein the favor of the firm, the collection can be expedited by

prompt encashment of the cheque. There is a lag betweenthe time a cheque is prepared and mailed by the customerand the time the funds are included in the cash reservoir ofthe firm. Within the time interval three steps are involved:

A) Transit or mailing time, that is, the time taken by thepost offices to transfer the cheque from the customer to thefirm referred to as postal float.

B) Time taken in processing the cheque within the firmbefore they are deposited in the banks, termed as lethargy;

C) collection time within the bank, this is called bankfloat.

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Contd

The early conversion of payment into cash, asa technique to speed up collection of accounts

receivable, is done to reduce the time lag

between the posting of the cheque by the

customer and the realization of money by the

firm. The postal float lethargy and the bank

float are collectively referred to as deposit

float. The term float is defined as the sum ofcheque written by customer that are not yet

useable by the firm.

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Contd

An important cash management technique isreduction in deposit float.

This is possible if the firm adopts he policy of

decentralised collections

The principal method of establishing

decentralized collection network are

Concentration banking

Lock-box system

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Concentration banking

Concentration banking is a system of operatingthrough a number of collection centers, instead of

a single collection center centralized at the firms

head office.

The basic objective of decentralized collection isto minimize the lag between the mailing time from

customer to the firm under this system the firm

will have a large number of bank accounts

operated in the areas where the firm has itsbranches.

All branches may not have the collection centers.

The selection of the collection center will depend

u on the volume of billin .bhushan30

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Contd

The collection centers will be required to collectcheques from customers and deposit it in their

local bank accounts.

The collection center will transfer funds above

some predetermined minimum to a central orconcentration bank account. A concentration bank

is one where the firm has a major account usually

disbursement account.

Funds can be transferred to a central or

concentration bank by telex or fax or electronic

mail.

Decentralized collection system saves mailing

and rocessin time and thus reduces the de ositbhushan31

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Lock-box system

Lock-box system another technique of speedingup the mailing, processing time and, collection

time is lock-box system.

In concentration banking cheques are received

by a collection center and after processing aredeposited in the bank.

Lock-box system helps the firm to eliminate the

time between the receipts of cheques and their

deposit in the bank.

In a lock-box system, the firm establishes a

number of collection centers, considering

customer location and volume of remittance.bhushan32

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Contd

At each center, the firm hires a post office boxand instructs its customers to mail their

remittance in the box.

The firms local bank is given the authority to pick-

up the remittance directly from the lock box.

The bank picks up the mails several times a day

and deposits the cheques in the firms account.

For the internal accounting purpose of the firmthe bank prepares detailed records of the

cheques picked up.

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Contd

Two main advantages are1. The bank handles the remittance prior to

deposit at a lower cost.

2. The cheques are deposited immediately upon

receipt of remittance and their collection

processes sooner than if the firm would have

processed them for internal accounting purpose

prior to their deposits.

Both the systems involve cost. Whether the

system should be used or no depends upon the

comparison between its cost and benefits.

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D l i t t

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Delaying payments on accounts

receivable

This can be done through:

Avoidance of early payments

Centralized disbursement Float

Paying from a distant bank

Accruals

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St t i f i l

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Strategies for managing surplus

cash

Do nothing: the financial manager simply allowssurplus liquidity to accumulate in the current

account. This strategy enhances liquidity at the

expense of profits that could be earned from

investing surplus fund. Make ad hoc investments: the financial

manager makes investments in some what ad

hoc (unplanned, unprepared) manner such a

strategy makes some contribution, though not theoptimal contribution, to profitability without

impairing the liquidity of the firm. It is followed by

the firms which cannot devote enough time and

resources to management of securities.bhushan36

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Contd

Ride the yield curve: this is a strategy toincrease the yield from a portfolio of marketable

securities by betting on interest rate changes.

If the financial manager expects that interest

rates will fall in the near future he would buylonger term securities as they appreciate more,

compared to short term securities.

On the other hand, if the financial manager

believes that the interest rate will rise in the near

future, he would sell longer term securities.

This strategy hinges (centered) on the

assumption that the financial manager has

su erior interest rate forecastin abilit .bhushan37

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Contd

Develop guidelines: a firm may develop a set ofguidelines which may reflect the view of the

management towards risk and return.

Examples of such guidelines are:

(i) Do not speculate on interest rate changes. (ii)

Hold marketable securities till they mature (iii) do

not put more than a certain percentage of liquid

funds in a particular security or instrument (iv)

minimize transaction cost

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Contd

Utilize control limits: there are some models ofcash management which assumes that cash

inflow and outflow occur randomly (irregular) over

time.

Based on this premise, these models define theupper and lower control limits.

When the cash balance touches the upper limit,

the model prescribes that a certain amount

should be invested in the marketable securities

and when the cash balance hits the lower limit

then a certain amount of marketable securities

should be liquidated.bhushan39

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Contd

Manage with a portfolio perspective: according tothe portfolio theory there are two key steps in portfolio

selection.

Define the efficient frontier: the efficient frontier

represents a collection of all efficient portfolios. Aportfolio is efficient if and only if there is no alternative

with (i) the same expected return and a lower

standard deviation, or (ii) the same standard deviation

and a higher expected return, or (iii) a high expected

return and a lower standard deviation

Select the optimal portfolio: the optimal portfolio is

that point on the efficient frontier which enables the

investor to achieve the highest attainable level of

utility.bhushan40

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Stone model

The Stone Model is somewhat similar to theMiller-Orr Model in so far as it uses control limits.

It incorporates, however, a look-ahead forecast of

cash flows when an upper or lower limit is hit to

take into account the possibility that the surplusor deficit of cash may naturally correct itself.

If the upper control limit is reached, but is to be

followed by cash outflow days that would bring

the cash balance down to an acceptable level,

then nothing is done.

If instead the surplus cash would substantially

remain that way, then cash is withdrawn to get the

cash balance to a redetermined return oint.bhushan41

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Contd

Of course, if cash were in short supply and the lowercontrol limit was reached, the opposite would apply.

In this way the Stone Model takes into consideration

the cash flow forecast.

The goals of these models are To ensure adequate amounts of cash on hand for bill

payments,

To minimize transaction costs in acquiring cash when

deficiencies exist, And to dispose of cash when a surplus arises.

These models assume some cash flow pattern as a

given, leaving the task of cash collection,

concentration, and disbursement to other methods.bhushan42

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Long term cash forecasting

Long term cash forecast are prepared to give anidea of the companies financial requirements in

distant future. They are not as detailed as short

term forecast.

Long term cash forecast can be made for aperiod of two three or five years .

Once a company has developed long term cash

forecast it can be used to evaluate the impact of

say new product developments or plant

acquisitions on the firms financial condition for a

long period.

Long term cash forecast reflects the impact of

rowth, ex ansion or ac uisition; it also indicatesbhushan43

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Contd

The major uses of long term cash forecast are: It indicates as companys future financial needs,

especially for its working capital requirements.

It helps to evaluate proposed capital projects. It

pinpoints the cash required to finance these

projects as well as the cash to be generated by

the company to support them.

It helps to improve corporate planning. Long term

cash forecasts compel each division to plan for

future and to formulate projects carefully.

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Short term cash forecast

It is comparatively easy to make short termforecasts. The important functions of carefully

developed short-term cash forecast are:

To determine operating cash requirement

To anticipate short term financing

To manage investment of surplus cash

Some more uses of these forecasts are:

Planning reduction of short and long term debts. Planning forward purchase of inventories

Taking advantages of cash discounts

Guiding credit policiesbhushan45

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Contd

Two most commonly used methods of short termcash forecasting are

The receipt and disbursement method

The adjusted net income method

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Cash budget

Cash budget is a statement of the inflows andoutflows of cash that is used to estimate its short

term requirements.

The cash budget is probably the most important

tool in cash management it is a device to help afirm to plan and control the use of cash.

It is a statement showing the estimated cash

inflows and outflows over the planning horizon.

In other words the net cash position (surplus/

deficiency) of a firm as it moves from one

budgeting sub period to another is highlighted by

the cash budget.bhushan