cash forecasting

Cash Forecasting&

Models for the Management of Cash and Temporary Investment

Working Capital Management

• Cash: Cash is the ready currency to which all liquid assets can be reduced.

• Near Cash: It implies marketable securities viewed the same way as cash because of their high liquidity.

• Marketable Securities: Short-term interest earning money market instruments used by firms to obtain a return on temporarily idle funds

Motives For Holding Cash

Cash management is one of the key areas of working capital management. There are four motives for holding cash:

1) Transaction motive, 2) Precautionary motive,3) Speculative motive, and 4) Compensating motive.

1. Transaction motiveThe transaction motive refers to the holding of cash to meet anticipated obligations whose time is not perfectly synchronized with cash receipts. 2. Precautionary motivePrecautionary motive is a motive for holding cash/near-cash as a cushion t meet unexpected contingencies/demand for cash. The unexpected cash needs at short notice may be the result of:Floods, strikes and failure of important customers;Bills may be presented for settlement earlier than expected;Unexpected slow down in collection of accounts receivable;Cancellation of some order for goods as the customer is not satisfied; andSharp increase in cost of raw materials.

The cash balances held in reserve for such random and unforeseen fluctuations in cash flows are called as precautionary balances. In other words, precautionary motive of holding cash implies the need to hold cash to meet unpredictable obligations. Thus, precautionary cash balance serves to provide a cushion to meet unexpected contingencies.

3. Speculative motiveSpeculative motive is a motive for holding cash/near-

cash to quickly take advantage of opportunities typically outside the normal course of business.

4. Compensating motiveCompensating motive is a motive for holding

cash/near-cash to compensate banks for providing certain services or loans.

The basic objectives of cash management are two-fold:

(a) to meet the cash disbursement needs (payment schedule)

(b) to minimize funds committed to cash balances.

Meeting Payments ScheduleA basic objective of cash management is to meet the payment schedule, that is, to have sufficient cash to meet the cash disbursement needs of a firm.The importance of sufficient cash to meet the payment schedule can hardly be over emphasized. The advantages of adequate cash are:1)it prevents insolvency or bankruptcy arising out of the

inability of a firm to meet its obligations; 2)the relationship with the bank is not strained; 3)it helps in fostering good relations with trade creditors and

suppliers of raw materials 4)a cash discount can be availed of if payment is made

within the due date.

5. it leads to a strong credit rating which enables the firm to purchase goods on favorable terms and to maintain its line of credit with banks and other sources of credit;

6. to take advantage of favorable business opportunities that may be available periodically; and finally,

7. the firm can meet unanticipated cash expenditure with a minimum of strain during emergencies, such as strikes, fires or a new marketing campaign by competitors.

• For example, a firm is entitled to a 2 per cent discount for a payment made within 10 days when the entire payment is to be made within 30 days. Since the net amount is due in 30 days, failure to take the discount means paying an extra 2 per cent for using the money for an additional 20 days. If a firm were to pay 2 per cent for every 20-day period over a year, there would be 18 such periods (360 days ÷ 20 days). This represents an annual interest rate of 36 per cent;

Minimizing Funds Committed to Cash Balances

The second objective of cash management is to minimize cash balances. In minimizing the cash balances, two conflicting aspects have to be reconciled. A high level of cash balances will, as shown above, ensure prompt payment together with all the advantages. But it also implies that large funds will remain idle, as cash is a non-earning asset and the firm will have to forego profits. A low level of cash balances, on the other hand, may mean failure to meet the payment schedule. The aim of cash management, therefore, should be to have an optimal amount of cash balances.

Factors Determining Cash Needs

The factors that determine the required cash balances are:

(1) Synchronization of cash flows

The need for maintaining cash balances arises from the non-synchronization of the inflows and outflows of cash: if the receipts and payments of cash perfectly coincide or balance each other, there would be no need for cash balances. The first consideration in determining the cash need is, therefore, the extent of non-synchronization of cash receipts and disbursements. For this purpose, the inflows and outflows have to be forecast over a period of time, depending upon the planning horizon which is typically a one-year period with each of the 12 months being a sub period. The technique adopted is a cash budget.

Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. Included in the short costs are the following:(1) Transaction costs associated with raising cash to tide over the shortage. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities.(2) Borrowing costs associated with borrowing to cover the shortage. These include items such as interest on loan, commitment charges and other expenses relating to the loan.(3) Loss of cash-discount, that is, a substantial loss because of a temporary shortage of cash.(4) Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans, stoppage of supplies, demands for cash payment, refusal to sell, loss of image and the attendant decline in sales and profits.(5) Penalty rates by banks to meet a shortfall in compensating balances.

Excess Cash Balance Costs

The cost of having excessively large cash balances is known as the excess cash balance cost. If large funds are idle, the implication is that the firm has missed opportunities to invest those funds and has thereby lost interest which it would otherwise have earned. This loss of interest is primarily the excess cost.

Procurement and Management

These are the costs associated with establishing and operating cash management staff and activities. They are generally fixed and are mainly accounted for by salary, storage, handling of securities, and so on.

Uncertainty and Cash ManagementFinally, the impact of uncertainty on cash management

strategy is also relevant as cash flows cannot be predicted with complete accuracy. The first requirement is a precautionary cushion to cope with irregularities in cash flows, unexpected delays in collections and disbursements, defaults and unexpected cash needs.

The impact of uncertainty on cash management can, however, be mitigated through (i) improved forecasting of tax payments, capital expenditure, dividends, and so on; and (ii) increased ability to borrow through overdraft facility.

Cash ForecastingAn estimation of the flows in and out of the firm’s cash account over a particular period of timeAn estimation of the firm’s borrowing and lending needs and the uncertainties regarding these needs during various future periodsIt enables firms to anticipate periods of surplus cash and periods where financing will be needed

Why forecast cash flows?

If NO forecast: Unanticipated cash shortages may occur Slowdown cash out flows to suppliers Late delivery of critical materials Shareholders and creditors may react

negatively

If Unanticipated/unplanned surplus of cash: No investment for getting interest/profit Financial plan and cash control system will be

deteriorated Financial health will not be sound Wealth maximization objective will not be

achieved

Applications of cash forecasts

• Capital Budget• Production Plan• Sale forecasts

Types of Cash Forecasts

Types of cash forecasts can be differentiated along two dimensions:

a. Length of the periods b. Approach to cash flows

• Length/Time basis: The length of the time can be daily, monthly,

weekly, yearly, etc. , sometimes for a longer time.

Distribution and Scheduling are also necessary.Distributions starts with data on relatively

longer periods and breaking it into smaller periods.

Scheduling starts with data on relatively shorter periods and aggregating into longer periods.

• Approach Basis: a. Receipts and disbursement approach b. Adjusted net income approach

The first one uses the amounts of cash expected to be received and disbursed by the firm over some periods chosen for the forecasts.

It is useful to control the firm’s cash system accurately

Adjusted net income approach tells about the sources and uses of funds.

Starts with projected net income on an accrual basis and adjusts to cash basis.

It shows the changes in assets and liability accounts.

But it cannot trace the individual cash inflows and cash out flows.

Items to be forecast

• Some possible types of cash receipts: Accounts receivable collections, notes

receivable, rental income, interest income, principal on maturing investments, dividends from subsidiaries, miscellaneous receipts

Items to be forecast• Some possible types of cash disbursements: Cash purchases of materials, payroll expenses,

Taxes, maturing accounts payable, mortgage payments, maturing notes payable-interest and principal, capital expenditures, utility payments, dividend-preferred and common stock, sinking fund payments-outstanding bonds, maturing bonds payment, payment to pension fund, market repurchase of outstanding stocks or bonds, miscellaneous disbursements.

Methods of financial forecasting

Financial forecasting is the estimation of the future level of a financial variable – cash flow, asset level or liability level.

A linear relationship between the financial variable and other variables.

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Spot Method

Variable to be forecast is independent of all other variables, or is predetermined. Such as rental payment as a fixed expenses.

Proportion to Another Account

Used to project financial variables that are expected to vary directly with the level of another variable. For example: percent of sales as cost of sales

11XaYt

Compound Growth

Used when a particular financial variable is expected to grow at a steady growth rate over time. For example: Dividend growth rate.

1)1( tt YgY

Multiple Dependencies

The variable is thought to depend on more than one factor; not just sales or some other variable but a combination of several variables. For example: Inventory level; firms keep a minimum portion as safety stock level and the rest is stored with the proportionate of demand.

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Forecasting collections from Accounts Receivable

Two major ways to make decisions here:

a. Forecasting Methodology: on either turnover

basis or payment approach basis

b. Degree of Aggregation: different lines/ sectors

• Assume that last month’s sales were $ 20,000, that this month’s sales are expected to be $ 30,000 and the next month’s sales would increase by 5 percent than this month’s sales volume. Also assume that 30 percent of the customers purchased products for cash, 40 percent pays in 30 days, the remaining pays in 60 days. Forecast cash receipts for next month by the turnover and payment proportions methods.

Sources of Uncertainty in Cash Forecasting

• Sales Uncertainty• Collection rate• Production cost• Capital Outflow: regarding future amount of

capital outflow which indicates the timing of cash disbursements and construction process.

Hedging Cash Balances Uncertainties

If there is no hedging system, the solution to the problem will be very costly occurred by deficit fund, it may deteriorate the relationship with the stakeholders.

The cash balances uncertainties can be hedged by: a. holding a stock of extra cash

b. holding a stock of near cash assets: treasury bills, repurchase agreements, etc.

c. Extra borrowing capacity from banks and financial institutions

Features of some hedging Strategies for Risks in Cash

• Hedge – Keep stock of extra cash• When Applicable – Hedges any shortages• Costs – Opportunity loss on investment in

amount of the firm’s costs of capital


• Hedge – Keep stock of near-cash assets• When Applicable – Hedges any shortages• Costs – Opportunity loss on investment in

amount of the difference between the after-tax return on the near-cash investments and the firm’s cost of capital


• Hedge – Invest temporary surplus in near-cash assets rather than longer-term assets

• When Applicable – During surpluses only• Costs – If yield curve is Upslopping difference

in yield between near-cash and longer-term assets; Transaction costs of purchase, reinvestment and sale of costs


• Hedge – Arrange for extra borrowing capacity• When Applicable – Hedges any shortages• Costs – Out-of-pocket expenses of applying

for and drawing down extra borrowing; Commitment fees on extra borrowing capacity for maximum needed hedge


• Hedge – Invest temporary surplus in longer-term investments and hedge interest rate risk with options on financial futures

• When Applicable – During surpluses only• Costs – If yield curve is Upslopping difference

in yield between near-cash and longer-term assets; Transaction costs of purchase, reinvestment and sale of costs

Selection Criteria• The choice of cash and investment mix is based on

trade off between opportunity to earn a return on idle fund during holding period and brokerage cost associated with purchase and sale of securities, considering the following facts:– Financial/default risk– Interest rate risk– Taxability– Liquidity– Maturity– Yield available

Determining Cash NeedThere are two approaches to derive an optimal cash balance, namely,

a) minimizing cost cash models and b) cash budget

Cash Management/Conversion Models:

1) Baumol Model 2) Beranek Model3) Miller-Orr Model4) Stone Model

Determination of Optimum Level of Cash Balance

• In order to invest the excess funds, the financial manager must know the minimum amount of cyclical requirement

• Also required to determine the optimal amount of cash and bank balances, and in what quantity the securities should be purchased or sold

• Certainty approach theory and uncertainty approach theory

Certainty Model- Baumol• This model considers that the firm is assumed to

receive cash periodically but pay out cash continuously at a steady rate.

• Has a portfolio of cash and marketable securities which earn a particular rate of return (i) per period regardless of the amount to be invested.

• Also assumes that marketable securities are uniformly and infinitely divisible

• For any transaction into or out of the portfolio, there is a fixed charge (b) per transaction independent of the amount of investment

• Total demand for cash (T) of the firm at a periodic interval is known

• The firm sells securities at a periodic intervals to replenish cash

• A firm begins with an amount (C) of cash balance. When this amount is spent, it replenishes the cash by selling (C) the same amount of securities

• When a firm receives cash inflows, it puts enough cash in its disbursement account to cover cash out flow until the next inflow is received

• Appropriate strategy for investing funds until they are needed next:– Two-transaction strategy– Three-transaction strategyAccording to the two-transaction strategy, when the

cash inflows is received, invest one-half of the total inflow, put the remaining one-half in the disbursement account. During the first half of the period, pay expenses from the disbursement account.

Investment Income = ¼ (iY)Profit = ¼(iY)-2a

According to the three-transaction strategy, initially invest two-third of it, place the remaining one-third into disbursement account, when this one-third is exhausted, disinvest one-half the investment account, put the amount of 1/3(Y) in the disbursement account and the remaining 1/3(Y) in the disbursement account through the remainder of the period.

Interest income = (2/3)(1/3)iY+(1/3)(1/3)iY=(1/3)iYProfit = (1/3)iY-3a

• In general, the optimal strategy should be a general expression for the optimal number of transactions

• Interest income = [(n-1)/2n]iY• Profit = [(n-1)/2n]iY-na• Number of transaction, n = • In Baumol model, the firm will always make one

deposit and (n-1) withdrawals from the investment account

• The amount of withdrawals will be (1/n)Y

aiY2

• Limitations of the Baumol Model are:– Specification of costs associated with security

transactions– Return in all the market is not always fixed– Steady usage of cash may not be always possible– It will not work if the uncertainty of cash flows is

very high– Does not deal with risk of cash flows

• A firm runs an apartment complex, cash comes in at the beginning of the month (from rental payments) and is disbursed uniformly through out the following month. For the upcoming month, the firm expects to have cash expenses of $250,000 which can be invested at 0.5 percent per month where transaction costs are $50 per transaction. What is the firm’s best investment strategy and how much will this earn?

Certainty Model- Beranek Model• Beranek hypothesized that cash inflows are steady,

but cash outflows are periodic• Cash flow pattern are the mirror images of the

Baumol model cash flow pattern• Cash would be collected continuously at a uniform

rate, but would be disbursed over a short time as a group of firm’s chesks reached its bank and were paid

• The challenge is to profitably invest the funds between the time of their receipts and the time when checks are presented to the bank for payment

• The optimal number of transactions, n =• The amount of final withdrawal =• Profit = [(n-1)/2n]iY-na • All cash flows are certain• Cash out flows are periodic and instantaneous• Cash inflows occur at a constant rate

aiY 2/Ynn ]/)1[(

• A firm receives $100000 per day which it will eventually need to make disbursements, and follows a policy of writing checks every two weeks. Over a two-week period, it accumulates $1400000. it can invest at an interest rate of 6.825 percent per year. The transaction cost of invest or disinvest is $ 37.50. what investment strategy should the firm follow and how much will it earn?

Uncertainty Model- Miller-Orr Model• Applicable when uncertainty of cash outflows is so

high, results random fluctuation in cash balances• Investment or disinvestment cost is fixed

irrespective of the amount of securities.• There is a lower limit below which the amount

cash balance cant go, if reached, transferred from market securities take places, by selling securities

• When cash balance goes above the upper limit, transfer of cash to market securities take places by purchasing securities

• When cash balance stays within these bounds, no transactions take place in spite of some amount of fluctuations in cash flows.

• Assumed that cash flows are normally distributed, the standard deviation of cash flows is not changed for a long time.

• Upper control limit (h), return point (Z), opportunity cost of holding cash (i) and security transaction cost (b)

• Here h= 3Z• Z =

ibs433

2

• A company projects, the daily net cash flows for the next seen days as follows:

• The policy of the company is to maintain a minimum cash balance of $10,000 at all times

• Fixed cost of transaction $1600, return on securities 10% p.a

• Determine the return point and the upper limit of cash holding for the firm

Day 1 2 3 4 5 6 7

Cash flow forecast

+24 +13 -16 -12 +36 +4 -28

Uncertainty Model- Stone Model• Applicable when management’s estimation of

future cash flow is required• There is inner control limits (UCL1, LCL1) and the

outer control limits (UCL2, LCL2) • Under this Stone model, strategy proceeds as

follows, the firm performs no evaluation until its cash balance falls outside the outer control limits, the firm adds the expected cash flows for the next few days to the current balances

• If the sum of the current balance and these expected future cash flows falls outside the inner control limits, a transaction is made

• If the forecasted cash flow is expected to move within the inner limits, the balance is closer to the target balance, no transaction is made, thus save the costs of transaction.

• If the forecasted cash balance is outside the inner limits, the closing balance is far away from the target balance, the manager orders buying and selling of securities so that closing balance becomes equal to the target balance.

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cash forecasting

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