Management of Cash

• It is the responsibility of the finance manager to provide adequate cash to the firm

• He has to also ensure that funds are also not blocked and thus remains idle

• The term cash is understood in two ways

– In narrower sense it is considered only as coins, currency notes etc

– In broader term it also includes the assets that can be readily convertible in to cash like marketable securities, bank deposits etc

Management of Cash

• Objectives of Cash Management

• Two basic objectives of cash management

1. To meet the requirement of disbursement need as per the payment schedule

1. Payment for wages, purchases, taxe, bills etc

2. Have minimum amount of the cash that is locked up in the cash balance

– both these objectives are mutually contradictory and thus it is very difficult for the to maintain a balance between the two

Management of Cash

• Cash Management involves the following 4 problems

1. Controlling the level of cash

2. Controlling the level of inflow of cash

3. Controlling the level of outflow of cash

4. Optimum investment of surplus cash

Management of Cash

• Cash Management involves the following 4 problems

1. Controlling the level of cash

• The Level of cash locked up in the cash balances should be only that amount which is required.

• This is achieved by preparing what is called the “ Cash Budget”

• Cash Budget– Cash budget is the cash forecast which involves the future projection of

the cash receipts as well as the cash disbursement

– It reveals the “timing” and “amount” of cash inflow and outflow over a period studied and thus is a tool by which the finance manager is able to plan things in a better way

Management of Cash

• Cash Budget• Cash budget is prepared by estimating the cash receipts from

various sources and the cash payments to different agencies

• The cash receipts and payments are divided in to 2 categories

• Cash Receipts

1. Capital Receipts• All the money that is coming by way of capital fund raising like issue

of shares, loan raised by issuing debentures or preference shares

• Cash received when some long term asset has been sold

2. Revenue Receipts• Cash received by sales of goods /services

• Commisions

Management of Cash

• Payments

1. Capital Payment• The amount given to the bond holders on the maturity of the bonds

• Payment of long term loan

• Purchase of some long term fixed assets like plant or machinery etc

2. Revenue Payment• Payment for raw materials purchases

• Payment of wages, bills, rents

• Payment of interest on long term loans

• Payment of dividends on shares etc.

Management of Cash

• Preparing the cash balance ( for a specific time period)

• Three basic steps

1. Opening Balance

2. Add cash receipts and deduct the payments made

3. Prepare the closing balance( which will be the opening balance for the

next time period)

• Example

• Estimate the cash budget for the month of January 1998 from the following

– Cash in hand ( on 1.1.1998) = Rs 20,000

– Sales ( December 1997) = Rs 50,000

– Sales ( January 1998) (estimated) = Rs 80,000

– 80% of amount is recovered in the month of sales and the balance in the received in the subsequent month

– A sales commission of 5% is paid in cash in the month of sales itself

– Purchases• For December 1997 = Rs 20,000

• For January 1998 = Rs 30,000 (estimated)

• No credit policy is allowed by the suppliers

• Example ( solution)

– Opening balance as on 1.1.1998 = Rs 20,000

– ADD Receipts• Sales ( December 1997) = 20% of 50,000 = Rs 10,000

• Sales ( January 1998) = 80% of Rs 80,000 = Rs 64,000

• Total Cash = Rs 94,000

– Less Payments• Sales commission ( for January 1998)= 5% of 80,000 = Rs 4,000

• Purchases ( for January 1998) = Rs 30,000

• Total Payments = Rs 34 000

– Closing cash balance as on 31.1.1998 = Rs 60,000

Management of Cash

1. Prepare the cash budget for the month of May and June 1999 from the following information

2. Cash balance as on 1 May 1999 is Rs 8000

3. Advance tax of Rs 8000 each is payable in March and June

4. A Plant costing Rs 16,000 is due in July

5. Period of credit allowed 1. Suppliers = 2 months

2. To customers = 1 month

6. Lag in the payment of manufacturing expenses = 0.5 month

7. Lag in the payment of office and selling expenses = 1 ,month

Month Credit Sales Credit Purchase

Wages ManufacturingExpenses

Office Expenses

Selling Expenses

March 60,000 36,000 9000 4000 2000 4000

April 62,000 38,000 8000 3000 1500 5000

May 64,000 33,000 10,000 4500 2500 4500

June 58,000 35,000 8500 3500 2000 3500

Month May June

Opening Balance 8000 13,750

Estimated Cash Receipts 62,000(sales of April realized in May)

64000 ( sales of May realized in June)

Total 70,000 77,500

Estimated Cash Payments

(Credit Purchase)To suppliers ( 2 months)

36,000 38000

Wages( No Condition) 10000 8500

Manufact. Expenses 1500+2250= 3750 1750+2250= 4000

Office Expenses 1500 2500

Selling Expenses 5000 4500

Plant Expenditure Nil NIL

Advance Tax payment Nil 8000

Total 56,250 65,500

Closing Balance 13,750 (as on 31.5.1999)

12,250 (As on 30.6.1999)

• 2 Controlling the Inflow of Cash

– After preparing the cash budget the finance manager should ensure that there is no deviation in the inflow of the cash

– Any deviation from the expected cash inflow can lead to upsetting of the whole budget activity

– The Finance manager needs to devise appropriate techniques so that the cash coming to the firm should not get diverted to anywhere else

– The cash should also come on time

Techniques to control the Inflow of Cash

– Concentration Banking

• Decentralized system of account receivables, for the firms having their operations spread over a large geographical area

• The firm establishes a large number of collection centers in different geographical areas

• The collection centers deposit the cheques from the debtors to the local branch of the bank

• The local bank transfers a certain amount of money on daily basis to the Bank at Head office

• This results in the faster collection of the funds

– Advantages of Concentration Banking

– Reduction in Mailing Time

• The time required for the cheque from the customer to be received by the firm is called mailing time. As a result if the local collection centre the mailing time is reduced considerably.

• Quicker collection of cash

Techniques to control the Inflow of Cash

– Lock Box System

• A further step in speeding up of the collection of cash.Incase of concentration banking the cheques are received by the collection centers and then deposited in the bank by the collection centers

• While in Lock Box System the firm hires the PO boxes and gives the authority to the bank to pick the remittances directly from the lock box and deposit in the forms account directly.

• This reduces the gap further in the collection of check and the deposit of the check

• The bank picks up the mail several times daily and deposit the cheques in the firms account

• 3 Controlling the outflow of Cash

– This relates to the cash payment to be given to the creditors

– Here the aim is totally opposite to what one has in controlling the cash inflow

– Here we want to delay the payment as much as possible and thus want to slowdown the process

– The combination of the faster collection and slow disbursement leads to maximum availaiablity of funds

• How the Controlling the outflow of cash in done

– Decentralized system of disbursement

– Payment should be made only on the due date and not earlier than due.

• 4 Investing the surplus cash

– There are 2 problems that the firm face while taking the decision to invest the surplus cash

1. Where to invest1. Which type of security

2. For how much time

3. Liquidity etc

2. Determine the amount of surplus cash in hand– The cash in excess of what is considered the “normal cash

requirement” of the firm is called the excess cash.

– So FM needs to know what is the “ normal cash requirement”

– This “ normal cash requirement” is also called the safety level of cash

– How to determine this “safety level of cash” ?

• How to determine the safety level of cash

• How to determine the safety level of cash

– Two cases

– Normal Period Safety level Cash

• Safety Level of cash = Desired days of cash X Avg daily cash outflow

• Example– A FM feels that I should have sufficient funds to meet the cash requirement for 7

days and the average daily cash outflow for those 7 days is Rs 6000/day

– Safety Level of cash = 7 X 6000 = Rs 42,000

– Peak Period safety Level of cash– Safety Level of cash = Desired days of cash X Avg daily cash outflow of

peak period

– Example : Avg daily cash outflow for the peak days was Rs 4000 and a FM wants to have sufficient cash for the 5 peak days

– Safety Level of cash = 5X 4000 = Rs 20,000

• Models to determine the optimum level of cash

– Baumol Model

– Miller-Orr Model

• Baumol Model

– This model is based on minimization of 2 costs• Carrying cost

– When the firm holds cash and it is not in circulation the firm is loosing the opportunity to invest it somewhere. This is also called opportunity cost and in this model it is called the carrying cost

• Transaction Cost– When a firm has kept its cash in securities that can be converted in to cash , it has to

pay certain costs like commissions, admin costs etc. This is called the Transaction cost

– As per this model that amount of cash( both in hand and in securities) is the optimum where total of the 2 costs in minimum

• Models to determine the optimum level of cash

– Baumol Model

C = 2 X U X P

S

where

C = Optimum Cash Balance

P = Fixed cost per transaction

S = Opportunity cost of 1 Rs per annum( or per month)

U= Annual or monthly cash requirement

Example: Monthly cash requirement by the Firm Rs 60,000

Fixed cost per transaction = Rs 10

Interest rate on market securities/FD = 6% pa

Calculate the optimum cash balance

• Models to determine the optimum level of cash

– Baumol Model

C = 2U X P

S

C = 2 X 60,000X 10

0.005

C = Rs 15,942

• Models to determine the optimum level of cash

– Miller-Orr Model– Baumol model is suitable where the cash outflow is steady and can be

predicted with accuracy in advance

– Where the cash flows are random Miller-Orr model is used

– This model consists of setting an upper limit, lower limit and return point for the cash.

– Upper limit is represented = h

– Lower limit = O

– Return Point = z

• Models to determine the optimum level of cash

– Baumol Model

z = 3 3 b σ2

4 i

where

Z = Optimum Cash Balance

b = Fixed cost per transaction

σ2 = Variance of the daily net cash flow

i= interest rate on the marketable securities (per day)

This model thus also seeks to achieve the minium of the transaction and the opportunity costs