16 Managing Managing Cash

Reasons for Holding CashCash is justifiably considered to be the most unproductive of all assets. In fact, any asset that is idle, or is held in a quantity greater than necessary, is unproductive. You will recall that a firm raises capital at a cost, and uses the funds raised to buy assets. Now if an asset is bought but not used, it incurs costs without producing returns. The situation is more serious in the case of cash because idle cash on the one hand attracts costs and on the other loses value due to inflation. So why do companies hold cash? There are essentially three reasons, or motives, for holding cash: transactional motive, precautionary motive and speculative motive.

Transactional MotiveCash is needed to meet day to day transactions of the company. Paying routine expenses and meeting regular payment obligations to suppliers and lenders is necessary to keep the business wheels turning. A certain quantity of cash must therefore always be available to prevent the business from coming to a grinding halt.

Precautionary MotiveIn addition to routine commitments, a company must also keep some cash for meeting any unforeseen or unexpected outflows, e.g. an accident in the factory demanding immediate heavy repairs, a fire in the warehouse that suspends supplies to customers and therefore dries up incoming cash flow, an unexpected demand from a lender to pay up before due date, etc. Just as households maintain a small savings nest to meeting the unforeseen expenses, so do businesses maintain a decent cash balance for precautionary reasons.

Speculative Motive

Sometimes, a company comes across an opportunity too good to be missed. Advantage of such a situation can only be taken if there is sufficient cash available. For example, if a manufacturer is getting rid of its old stock and is willing to offer a handsome discount to any one who is willing to buy the entire stock for cash, or on very short credit terms, a wholesaler may benefit tremendously if he is able to seize the moment. A degree of liquidity is needed to benefit from such opportunities.

Cash, Near Cash and Potential CashThese three terms are frequently used in relation to liquid funds held or needed by a company. Cash of course includes physical cash comprising of currency notes and coins held in the office, at the factory or at branches of a company. In addition, it also includes cash held in savings or current accounts of a bank from where it can be withdrawn without any notice or penalty. Near Cash refers to bank balances or marketable securities held by a company which can be converted into cash at a minimum of notice or loss or penalty. For example, cash held in a term deposit account can often be withdrawn by giving a short notice and foregoing some interest income. Similarly, marketable securities like government bonds or shares of listed companies can be liquidated almost immediately but at a possible loss. Potential cash essentially refers to borrowing facilities available to a company which it has not yet fully utilized. For example, if a company has negotiated a bank overdraft limit of say Rs. 2,000,000 but it has currently overdrawn only Rs. 745,000, it has a potential cash balance of Rs. 1,255,000. When managing cash, a finance manager should look at all forms of cash. For example, there is little justification in maintaining large cash balances in current account, or even in near cash form, for speculative reasons. Making timely arrangements for potential cash can equally serve the speculative motive for holding cash.

Cash Management PolicyA company must draw up a formal cash management policy. The basic contents of the policy are:

a. Procedures for opening and operating bank accounts of the company clearly laying down the scope of authority for all concerned officials in this regard.

b. Procedures for receipt and banking of funds.c. Procedures for making payments, and moving funds within different

accounts of the company, clearly defining the authority limits for those approving the payments

d. Procedure for and authority of officials who can negotiate loans etc. on behalf of the company.

e. Guidelines for levels of cash to be held in different forms (e.g. cash in hand, cash at bank in current account, near cash, etc.) at different times of a financial year.

Main Problem with Cash Management

The main problem experienced in management of cash is the fact that it cannot be managed in isolation. Cash flows are results of other activities taking place in the company. All cash management procedures must be tailored to meet the cash needs of the operating cycle of the company – not the other way round. A company cannot normally be asked to alter its normal course of business to suit its cash manager. This is a big challenge which can only be met through meticulous planning, carefully drawn procedures and quick action by finance manager at the appropriate time.

The Main Objectives of Cash Management PolicyWhat does a finance manager expect of get out of a cash management policy? Essentially, a company aims at two things: that it is never short of cash and that it never has too much idle cash. Thus the objectives of the cash management policy are:

a. The company should be able to meet all its payment obligations on due dates so as not to lose any goodwill. This is extremely important. If a company fails to pay its (trade or other) creditors on time, it will lose goodwill which in turn can expose it to several other risks, including inability to get supplies on time, recalling of its loans before due date, etc. In order to accomplish this objective, a finance manager must carefully chart out the company’s cash operating cycle, so as to be aware of the times when there is likely to a be a cash shortage. Once the timing and magnitude of the likely shortage are known, suitable arrangements can be made in advance to avoid the shortage and its negative consequences.

b. The amount of idle cash held should be minimized. Idle cash is a waste of resources. Just as preparation of cash flow plans can indicate the times when a company may experience cash shortages, it can also divulge the times when there is likely to be cash surpluses. If the finance manager knows the timing and the duration for which cash is likely to remain idle, he can put it to alternative use, thereby generating some income.

How much cash should be held?Much like stocks and debtors, the level of cash to be held depends on the balance between cost of holding cash and the benefits to be obtained from holding cash. However, one thing to remember here is that cash is not a commodity like stock that can be bought whenever a need arises for it, nor can it be disposed of without incurring a loss. Hence, the importance of planning cash flows. Another important aspect is the form in which cash should be held, i.e. what portion of the available cash should be held in the form of physical cash, in current account, in short term deposits, or as marketable securities. The answer to this can be provided by the cash planning exercise discussed later in this chapter.

Cost of Keeping CashThe costs of keeping idle cash are:

a. As already pointed out, idle cash attracts cost of capital. It is naïve to think that only borrowed funds have a cost. As a student of finance, you will by now be able to appreciate that any resource put at the disposal of the company has a cost.

b. In addition, cash loses value over time due to inflation.

c. Cash lying in company’s safe or current bank account also deprives the company of the profit that it could make by investing it elsewhere. This is the opportunity cost of idle cash.

d. If surplus cash in held in the form of marketable securities, these may lose value due to market fluctuations. The possibility of loss due to an element of uncertainty also applies to funds held in the shape of foreign currencies as they are equally liable to lose value.

Benefits of Keeping Cash The benefits of keeping a healthy cash balance are:

a. It saves the company from the effects of cash shortages. As stated earlier, cash shortage results in a failure to meet one’s payment obligations on time. This leads to getting poor treatment from suppliers, having to pay higher prices, inability to get adequate credit, failure to get stocks when these are in short supply as sellers prefer to serve the better paymasters, etc. All these things translate into costs which can be saved by having sufficient cash to meet routine payment liabilities.

b. If a company pays its lenders on time, it is likely to get a reduction in interest rates when these come up for revision, or easily get an extension in credit volume. Better goodwill and improved credit ratings follow. These lead to lower cost of borrowed funds for the company in the future.

c. Adequate cash balances make it possible for the company to avail cash discounts offered by the supplier. Experience shows that cash discount is generally offered by companies in financial difficulties. Hence, the effective rate of cash discount is generally above the cost of capital for the paying companies.

How can a company improve its cash positionCash position has two active ingredients: inflows and outflows. So essentially the way to improve the cash position of a company is to speed up its inflows and slow down its outflows.

Methods of improving Cash CollectionsThe following methods and techniques are available to companies for speeding up their collections:

Control Cash Operating CycleThis is the time it takes a company to collect cash from its operations. It is the total of average number of days for which raw material, work in process and finished goods inventories are held plus the average credit allowed to debtors. One simple way of improving cash position is to try to reduce the duration of cash operating cycle. This can be done by lowering the level of all inventories and reducing the credit terms allowed to debtors. As you learned in previous two chapters, there is limit to which a company can cut down its inventories and receivables. Going beyond that limit can prove counter-productive.

Prompt follow up on debtorsPerhaps the largest slice of a company’s cash flows comes from its debtors. By maintaining a prompt follow up on debtors, a company can improve its cash position without formally cutting down the credit terms. Follow up includes timely sending out of invoices and monthly statements of accounts and maintaining a regular liaison with debtors. For example, if a company allows 30 days terms to its clients, it must dispatch its monthly statement in good time and its staff must approach the clients promptly on 30 th day to collect the cheque. If it is left to the debtors, they might intentionally or otherwise take a few more days to settle their bills. This is all the more true in countries like Pakistan where debtors conveniently pretend that if a creditor does not remind them, he does not need the money. An informal survey has revealed that by regularly sending staff members to personally collect the payments from debtors, companies can reduce the average number of days taken by their debtors to pay by as many as five days.

Prompt bankingA company cannot use its cash unless it has been credited to its bank account. Hence, it is very important to promptly deposit all the receipts. Experience in Pakistan has shown that inefficient firms take two to three days to take their deposits to the bank, whereas efficient companies bank their receipt two to three times a day. Considering that most banks offer evening banking service, there is no justification for delaying deposits even for a day.

Concentration bankingThis refers to an arrangement whereby a company opens bank accounts in all the various towns where it has customers. All customers are asked to send their remittances to the bank in their respective town, or the staff members are asked to personally collect the cheques and deposit them with the bank in their town. Each bank in such towns is given specific instruction that all collections must be sent to the head office account, every day. In this way, the company saves the time taken by postal services to deliver the cheque from a customer to the head office of the company. Today’s banks are equipped with latest information technologies. They are capable of providing instant credit at the head office for deposits made in different towns. This can greatly assist the company in improving its cash position.

Selling off your receivables

This refers to an arrangement whereby a creditor can get cash against his trade receivables from a financial institution – by of course foregoing a part of them as interest. This can take a number of different forms, e.g. simply pledge the trade debtors and get a loan, or transfer the right of receiving money from trade debtors to the financial institution with or without retaining basic responsibility for repayment. In this way, by foregoing a small portion of the debtors (interest on the facility) a company can effectively turn all its credit sales into cash sales. Unfortunately, such discounting facilities are not widely available to businessmen in Pakistan. The reason banks are not keen at providing finance against receivables is the lack of proper credit rating system in the country. If the debtors are rated by an independent credit rating agency, banks are able to evaluate the risk of accepting debtors as a security for providing cash to the creditor, and accordingly set the interest rate. There are at least two credit rating agencies in the country but the common businessmen are not prepared to get themselves rated as most of them are unable to meet the documentary and audit requirements of the agencies. However, with the passage of time, it is hoped that more and more businessmen will learn the benefits of streamlining their systems, applying for credit rating and getting better treatment from their suppliers. In turn, this will enable the suppliers to provide them with longer credit terms as suppliers will be in a position to get their receivables discounted by banks.

Offer Cash Discounts This can help a company improve its collections from debtors. As long as the discounts offered do not cost the company more than its cost of funds, it makes sense to offer discounts and collect receivables within a short period.

Methods of controlling cash outflowsA company can use the following methods to slow down cash outflows without damaging its goodwill or credit rating:

Negotiate better terms with suppliersSkilful negotiations with creditors to increase the credit period can help a company vastly improve its cash position. Wholesalers, particularly in pharmaceutical industry, are known to negotiate up to 90 days credit from manufacturers while extending only 20 to 30 days credit to their own clients. In this way, they manage to operate their business without any investment in working capital at all. However, duration of credit period depends on a number of factors and all of these factors must be taken into account before deciding how much credit to avail. As it is often said, there is no free lunch in business. A supplier who is willing to offer longer credit terms will certainly compensate himself with higher prices.

Take full benefit of credit periodOnce a credit period has been agreed with a supplier, payment should not be made before the expiry of that period. Even small amounts should not be paid before the due date. It is a question of financial discipline that payments must be made only when due. Paying a creditor before time does not earn the company any goodwill or a financial reward; so there is no justification for it.

Issue cheques from other towns / play the floatOne way to delay payment to creditors without being accused of doing so is to issue them cheques from different towns. For example, a supplier in Karachi should be sent a cheque drawn on an Islamabad branch. In this way, money will stay in company’s accounts till the cheque is presented, four or five days later, to Islamabad bank. This is often called playing with float. However, with banks offering fast collection services and internet banking, playing with float is becoming a thing of the past.

Centralized paymentsPerhaps one of the most effective way of controlling cash outflows is to have a centralized payment system. All payments (beyond a certain minimum, say, Rs. 2,000) should be made only by the head office. In this way, the finance department remain fully aware of its payment obligations and can plan to meet them in an orderly manner. If branches or sub-offices are allowed to make their own payments, the company as a whole loses the ability to prioritize its cash outflows. For example, Peshawar branch may make a large relatively less important payment without knowing that Faisalabad branch needs to make a crucial payment and is missing funds for it. A centralized payment system takes care of these problems.

What to do with surplus CashIf a company manages its cash well enough, it is likely to be in the happy position of having surplus cash at certain times of the financial year. Making productive and prudent use of surplus cash can add to the profits of the company. When considering alternative use of surplus cash available to the company, the most important factor to consider is the duration for which the surplus cash is available. This can be ascertained by drawing up proper cash budgets (discussed later in this chapter). For example, a company dealing mainly with summer related items (e.g. an electric fans manufacturer) may find surplus cash in the months of summer, but this surplus may not last for more than a few months. Hence, it cannot be invested in any long term project. However, in certain cases, the cash budget may disclose that a certain amount of cash will be in excess of normal operational needs throughout the year. In such a case, long term usage of that amount can be contemplated.

Uses of Short Term Cash SurplusIf surplus cash is available for only a short period, at the end of which it will be needed for routine purposes, it can be invested in any of the following ways:

a. Placing the money in savings account that carries some interest rate.b. Placing the money in short term deposit accounts (say for three or six

months) that generally carry better rate of interest than savings accounts.c. Buying marketable securities carrying some rate of return, or an

expectation of profit through increase in market value.

d. Buying short term treasury bills. However, in Pakistan treasury bills can only be bought by financial institutions and are generally sold in very large lots.

e. If the surplus amount available is large enough, it can be placed in the call market in Karachi. Generally placements in call market – a market for short term deposits – can only be done through banks and other financial institutions. Placements by common businessmen at the call market are quite rate.

Uses of Long Term Cash SurplusIf the cash budget shows that a company will have a consistent cash surplus throughout a financial year, it can mean that a company can safely remove that much cash from the current assets part of its investments and use it for other than normal operational needs. These could include:

a. Paying dividends to shareholders. Assuming that payment of normal end of the year dividend is already provided for in the budget, availability of permanent cash surplus can enable a company to pay interim dividends – thereby enhancing its markets posture and share value.

b. Prepaying long term loans. It is to be believed that normal loan repayments will be built into the cash budget. If the budget still shows long term cash surplus, it makes sense to prepay the more expensive long term loans off, thereby savings interest costs.

c. Buying fixed assets or initiating new projects. This can generate more profits for the company by increasing its productive capacity.

How to Cope with Cash ShortagesIf the cash budget shows that the company is likely to experience a cash shortage at any time during the financial year, it is necessary to make arrangements well in advance to meet such a shortage. Well-planned borrowing can be cheaper and safer for the company. However, when making arrangements for meeting anticipated cash shortages, the most important factor to consider is the duration of the shortage. Arrangements to be made to handle short term shortages may be quite different from those needed for long term shortages.

Meeting Short Term ShortfallsShort term shortages are taken to be those that arise only for a part of the financial year. Cash generated from the normal operations of the company in periods following the shortfall is able to wipe off the deficit during the same financial year. So the company needs to make arrangements for only a short period of time. The following alternatives are generally available for this purpose:

a. Negotiations may be made with the suppliers to enhance the credit period. This will generally carry a lower cost and lesser hassle than is involved in documentation and securitization of loans from financial institutions.

b. If the cash budget shows a capital expenditure during the months of cash shortfall, it can be deferred till the cash position improves. In certain cases, this may not be possible but where it is possible, this appears to be the least painful of alternatives.

c. The last recourse is to borrow short term funds from banks or other financial institutions. Several forms of borrowing are available including:o Running finance facility (also known as overdraft). Under this

arrangement, bank allows the customer to overdraw his current account up to a stated limit. Interest is charged only on the actual outstanding balance at the end of each day.

o Short term loan for a fixed period. Under this arrangement, bank disburses the entire amount of the loan at the beginning of the credit period and charges interest on the whole amount for the entire period of credit.

o Function-specific facilities like import finance, export finance, raw material pledge finance etc.

Most companies that have seasonal business make these short term financing arrangements well in advance so that when the crunch months arrive, they are all ready to handle the situation.

Handling Long Term Cash ShortfallsIf the cash flow projections, i.e. the cash budgets, show a persistent cash short fall through out the financial year, this simply means that the company has not invested sufficient long term funds in working capital. One good preliminary step to take is to prepare cash forecasts for more than one year – say for three to five years. If these show cash shortfall to continue over a sustained period, the only solution is to inject permanent funds. These could either be equity funds raised through issuing new shares or long term debt from a financial institution or issue of bonds to general public.

Cash BudgetingPreparation of a cash budget is perhaps the most potent tool available to financial managers for managing their cash flow situation. It helps them see, with some degree of accuracy, the cash balance position at the end of each planning period, generally a month. This gives them sufficient time to make arrangements for meeting the projected shortfalls or investing the expected surpluses. It also helps them move around major receipt and payment events in order to synchronise them. For example, if a major capital expenditure is being planned for April but the cash budget shows insufficient funds availability in that month, it may be possible to reschedule the capital expenditure to a month when adequate funds are likely to be available.

Similarly, if say July shows availability of surplus funds, certain major payments like interim dividends, can be brought forward.

Purpose of Cash BudgetingThe main purpose of cash budgeting is:o To forewarn the management of likely shortfall and/or surplus situations in

the financial period. o To synchronize cash inflows and outflows where possible in order to

minimize interest costs and optimize investment income.o To let every manager know of his respective responsibility in relation to

cash management. For example, a cash budget may clearly lay down the collection targets for sales staff to ensure that cash flow from debtors remains within planned parameters. Similarly, expenses are controlled by setting payment limits for each period.

o When preparing the cash budget, input is sought from all relevant managers like sales staff, credit control staff, supplies staff, inventory controllers, production planners, etc. This therefore helps in coordinating the activities of various departments with the objective of meeting the common goal of the company, namely enhancing profits.

Budget PeriodCash budgets are generally prepared for one year at a time, broken down by months. A typical cash budget will have 13 columns, one for each month and the last for the total year. Some larger companies may even prepare weekly cash budgets but there are only a few who need to go to that detail. As a matter of routine, cash budgets are prepared annually but revised twice or thrice during the year, or upon occurrence of a major event impacting the cash flows.

Cash Budget FormatA cash budget is generally prepared on the same basis as a company writes its cash book. It has two major sections: receipts and payments. Each major source of receipt (e.g. cash sales, receipts from debtors, other incomes, etc.) is given a separate line, with a total receipts line at the end of this section. Similarly, each major payment head (e.g. creditors, various overheads, capital expenditure, etc.) is given a separate line, with a total payments line at the end of this section. Three further lines follow: the first showing the deficit or surplus for the month, the second showing balance brought forward from the previous period, and the last showing balance being carried forward to the next period.

Practical Steps in Cash Budgeting Procedures for preparing a cash budget differ from company to company. Some make very elaborate arrangements, with the process lasting several weeks, while others may carry out the exercise in an informal manner. However, the following are essential steps that must be gone through to ensure that the resultant cash budget is reliable.

Stage 1 Estimate Sales Revenue

This is done in the following distinct steps:

Step 1 Estimate Sales VolumesThe starting point is always the estimate of sales quantities. It is the sales volume on which all other actions of the company are based. Estimates for sales quantities of each product for each period must be agreed upon by all concerned (like marketing, production and finance staff, etc.) after a thorough discussion between them on all related matters like market conditions, economic situation, seasonality of sales, etc. Step 2 Setting Sales PricesOnce the sales volumes for each month of the budget year have been agreed upon, the next step is to decide the sales prices. This stage also includes consideration of trade discounts, quantity discounts, stock write off prices, etc. After the sales prices have been decided, sales revenue can be worked out by multiplying sales quantities for each product with relevant prices.

Step 3 Estimate Sales CompositionsThis means making estimate about what portion of the sales will be sold for cash, and what on credit. Again, out of the credit sales what portion will be collected within what period. This is important as it will impact on when the actual sales revenue will be collected in the form of cash.

Stage 2 Estimate other receiptsIn addition to revenue from sales, a company may also receive cash from certain other sources like: Income from rent or dividends on investments, interest on deposits, etc. Raising long term loans, Sale of fixed assets, Issue of new shares, etc.

Some of the above are fixed in terms of time, i.e. as to when they will be received. Examples of such receipts are interest on deposits which are credited by banks on pre-set dates, dividends on shares held, rent on properties, etc. Certain others receipts may have some flexibility and it may be possible to shift them around to suit the need of cash flow management, e.g. sale of a fixed asset may be scheduled when cash flow projections show a shortfall.

Stage 3 Estimate Payments for Production and ExpensesA detailed discussion on components of cost of production is outside the scope of this elementary text. However, briefly, estimates need to be made about cost of raw material and packaging materials to be used, cost of direct labour and cost of various factory related expenses called production overheads. The following steps are involved:

Step 1 Raw Materials

When making estimate of raw material and packing material costs, it is important to include the following:

Estimate the quantity and price of each raw material item to be used for each of the products to be manufactured and sold over the budget period.

How will the production be carried out? For example, will it be based strictly on sales quantities for each period, or will it be independent of each period’s sales.

Once the production plan is worked out, the next step is to estimate when the raw materials will be actually bought. Will these be acquired in the month of production or some time before it? Will certain stock levels be necessary to be maintained due to seasonal availability?

Once the raw materials purchase plan is agreed, the next step is to establish the credit terms that will be received from the suppliers. This will clearly determine the timing and volume of the cash outflows on this account.

Step 2 Direct LabourWhile most accounting and costing books define direct labour as a variable cost, the practice in Pakistan shows that wages paid to workers are fairly fixed in nature. Most workers are nowadays paid on the basis of time and not on piecemeal rate. Hence, estimates of labour cost are generally made on the same basis as administrative salaries, i.e. as a time related cost and cash outflow.

Step 3 Production ExpensesThe next step is to estimate the various production related expenses like energy cost, machinery maintenance, repairs, stores and supplies, factory rent and rates, etc. Some of these expenses may be paid in advance, some in the month of production and some a while after the month of production. This division must be carefully estimates as it will impact the timing and volume of cash outflow on this account.

Step 4 Estimate Other OverheadsThese include administration related expenses, sales, marketing and distribution related expenses and financial expenses. While most of these expenses are time related and may be divided evenly over the various months of the budget year, some may be paid later than others. For example, cost of placing advertisement in newspapers or television is often paid one to two months after the appearance of the adverts. All these factors should be considered when estimating the amount and timing of payment of these expenses.

Stage 4 Estimate Other PaymentsThese include payments for non-routine expenses like repayment of long term loans, purchase of fixed expenses, dividend payments, redemption of shares or bonds, etc. Some of these payments are compulsory and must be made on specified dates, e.g. loan repayments, while others can be shifted around to suit the cash flows. For example, purchase of a fixed asset or

payment of interim dividends can be scheduled for a month that has adequate cash balance.

Stage 5 Balance the Cash BudgetThis involves finding out the cash deficit or surplus for each month, adding it to the opening balance and finding out the closing balance. Many companies prefer to keep a certain minimum balance at the end of each month for precautionary and speculative reasons. Hence, if the closing balance as projected by the cash project appears to be less than the desired minimum balance, arrangements are needed to meet the shortfall. One way of handling these shortfalls is to shift around the discretionary receipts and payments. For example, a planned issue of shares may be moved forward, or a capital expenditure may be delayed. If the shortfall still persists, it calls for an external arrangement like obtaining a running finance facility from a bank.

On the other hand, if the closing cash balance being projected by the cash budget is significantly more the minimum balance required to be maintained, some shuffling around of discretionary receipts and payments may be done to eliminate idle cash, e.g. payment of interim dividends may be brought forward, some loans be prepaid, issue of new shares may be delayed, etc.

Balancing the cash budget stage is the most important part of preparing the budget. This enables the finance manager to synchronize receipts and payments which is one of the principal advantages of and reasons for preparing a cash budget. Once the desired closing balance for each month of the budget year has been reached, the budget should be sent for approval by appropriate authorities. After the approval, it should be implemented. While unforeseen events and matters outside the control of a company may cause projected collections or payments to be more or less than the budgeted amounts, efforts should be made to stay as close to the budget as possible to ensure that the basic objective of the cash planning is met: namely to meet all payment obligations in time and not to have idle cash at any time.

The following chart lists the stages involved in cash budgeting.

CASH BUDGETING PROCESS

Stage IEstimate Sales Revenue

a. Sales quantities for each product for each monthb. Sale prices, discounts, etc.c. Sale revenue for each month

d.Collection pattern, i.e. how much of each month’s sales will be received in cash in what month

Stage 2Estimate Other Receipts

a.Income from rent or dividends on investments, interest on deposits, etc.

b. Raising long term loans, c. Sale of fixed assetsd. Issue of new shares, etc.

Stage 3 Estimate Payments for expenses

a. Raw material usage, prices and purchase timings.b. Payment pattern, i.e. how much of each month’s

purchases will be paid for in cash in what month

c. Direct labor costs and payment timingsd. Production related expenses and their timingse. Other overheads and their timings

Stage IVEstimate OtherPayments

a. Long term loan repaymentsb. Capital Expenditurec. Dividend paymentsd. Redemption of shares or bonds

Stage V

Balancethe Cash Budget

a.Find the deficit or surplus for the month, add it to opening balance to establish projected closing balance

b.Shuffle around discretionary receipts and payments in order to obtain desired closing balance for each month

c.If internal sources are not adequate, make external sources for meeting the deficit

d.Re-balance the cash budget, get it approved and implement it.

ExampleGujrat Electric Fan Co. manufactures a single product.

a. Its projected sales for the last two months of 2006 and the first six months of 2007 are as follows:

November 2006 8,000 unitsDecember 2006 6,000 unitsJanuary 2007 6,000 unitsFebruary 2007 8,000 unitsMarch 2007 10,000 unitsApril 2007 12,000 unitsMay 2007 14,000 unitsJune 2007 14,000 units

b. Fans are sold for Rs 360 each. However, the company proposes to increase the selling price by 5% with effect from 1 March 2007.

c. 10% of the sales are against cash to small traders. 60% of the credit sales are paid for within a month and 38% of the credit sales within two months. The remaining 2% of credit sales are deemed irrecoverable.

d. Items are manufactured in the month preceding the month of sale. Thus units to be sold in March 2007 will be manufactured in February 2007.

e. Raw material cost per fan is expected to be Rs 200 per unit till the end of March 2007. After that it will rise by 5%. Raw material is bought in the month preceding the month of production. All purchases are on 60 days credit terms.

f. Details of production overheads are as follows:

o Direct Labour Rs 220,000 per month, paid in the month incurredo Electricity, at Rs. 6 per unit manufactured, paid in the month

following the production.o Plant maintenance, Rs 80,000 per month, paid in the month

incurred.o Depreciation, Rs 2,500,000 per annum.o Other production expenses, Rs 120,000 per month, paid in the

month incurred

g. Details of other overheads are as follows:o Office administration, Rs. 350,000 per month, paid in the month

incurredo Marketing and distribution expenses, 8% of sales paid in the month

of sales.

h. The company has a long term loan which is being repaid by quarterly installments of Rs. 850,000 in the second month of each calendar quarter.

i. The company plans to purchase a new machine in June at a total cost of Rs. 5.0 million. 30% of its price will be paid by the company and the rest will be financed by a leasing company. Repayments to lease company will start in the last quarter of the year.

j. A part of company’s buildings is sub-let to a tenant who pays rent of Rs. 80,000 per quarter, at the end of each calendar quarter.

k. The company maintains a minimum cash balance of Rs 100,000, which is expected to be the opening balance on 1 January 2007. Any cash in excess of this balance is transferred to a savings account that earns 6% interest. However, all transfers to savings account are in multiples of Es 100,000.

l. The company wishes to pay a dividend of Rs 1,000,000 after March 2007.

Prepare a Cash Budget for the first half of 2007, advising the company on the following issues:

o The most appropriate time to pay the dividend.o Does the company need to make any prior arrangements with its

bankers?

Solution:

Step 1: Estimate the amount of sales in each month.Sales are given in quantities. The unit price applicable in January 2007 is also given. It has been said that sales price will go up by 5% in March 2007. Since, actual receipt of sales proceed will involve sales made in two previous

months, we will need to estimate sales revenue for the last two months of 2006 as well as the first six months of 2007.

Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07Sales Qtty,

units8,000 6,000 6,000 8,000 10,000 12,000 14,000 14,000

Selling Price,

Rs/unit360 360 360 360 378 378 378 378

Sales Revenue,

Rs

2,880,000

2,160,000

2,160,000

2,880,000

3,780,000

4,536,000

5,292,000

5,292,000

Step 2: Calculate the amounts of cash and credit sales.o 10% of each month’s sales are against cash. These will be collected in the

month of sale.o 90% of each month’s sales are on credit. o Hence, the division of sales into cash and credit sales will be as follows:

Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

Total Sales2,880,0

002,160,0

002,160,0

002,880,0

003,780,0

004,536,0

005,292,0

005,292,0

00Cash Sales, 10%

288,000

216,000

216,000

288,000

378,000

453,600

529,200

5,29,200

Credit Sales, 90%

2,592,000

1,944,000

1,944,000

2,592,000

3,402,000

4,082,400

4,762,800

4,762,800

Step 3: Estimate the amount of cash to be collected each month from cash as well as credit sales.o 10% of each month’s sales will be collected in cash.o 60% of each month’s credit sales will be collected in cash in the following

month. Hence, 60% of December 2006’s credit sales will be collected in January 2007.

o 38% of credit sales will be collected two months later. Hence, 38% of November 2006’s credit sales will be collected in cash in January 2007.

o 2% of each month’s sales will be lost by way of bad debts. These will not appear any where in the cash budget.

o Hence, actual cash collection from cash and debtors in each month will be as follows:

Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

Cash Sales216,00

0288,00

0378,00

0453,60

0529,20

05,29,20

0

60% of Last Month’s Credit Sales1,166,

4001,166,

4001,555,

2002,041,2

002,449,4

402,854,6

8038% of Previous to Last Month’s Cr. Sales

984,960

738,720

738,720

984,960

1,292,760

1,551,312

Total Collection for Sales2,367,

3602,193,

1202,671,

9203,479,7

604,271,4

004,938,1

92

Step 4: Estimate other income and receipts.o There are only two other receipts.

o Rent income of Rs 50,000 will be received in March and June 2007.o A lease finance loan of Rs 3,500,000 will be received in June 2007.o Hence, other receipts will be as follows:

Jan 07 Feb 07 Mar 07 Apr 07May

07Jun 07

Rental Income 50,000 50,000

Lease Finance Loan3,500,0

00

Step 5: Estimate the cost of raw material to be used.o In order to calculate the cost of raw material to be used, first we need to

ascertain each month’s production.o It is given that each month’s actual production will be equal to next

month’s sale. Thus production in Jan 2007 will be equal to units to be sold in Feb 2007.

o Raw material is to be bought one month before production. This means units to be sold in March 2007 will be manufactured in February 2007 but raw material for these units will be bought in January 2007. Applicable price is Rs 140 per unit, going up to Rs 147 w.e.f. April.

o We are also told that payment for raw materials is to be made within 2 months. This means payment to be made in January 2007 will be in respect of raw material bought in Nov. 2006.

o The above information can be tabulated as follows:

MonthNo. of Units

To be sold

No. of UnitsTo be Made

Raw Material

bought for how many

Units

Price of Raw

MaterialRs/unit

Total Raw Material

Purchase

Payment to be

made for Raw

MaterialNovember 06

8,000 6,000 6,000 140 840,000

December 06

6,000 6,000 8,000 140 1,120,000

January 07 6,000 8,000 10,000 140 1,400,000 840,000February 07

8,000 10,000 12,000 140 1,680,000 1,120,000

March 07 10,000 12,000 14,000 140 1,960,000 1,400,000April 07 12,000 14,000 14,000 147 2,058,000 1,680,000May 07 14,000 14,000 16,000 147 2,352,000 1,960,000June 07 14,000 16,000 12,000 147 1,764,000 2,058,000July 07 16,000 12,000August 07 12,000

Step 6: Estimate labor expense.o Labour expense is given as a flat Rs 200,000 per month for Jan to Mar

2007 and increasing to Rs 242,000 (i.e. a 10% rise) with effect from April 2007.

o This can be tabulated as follows:

Jan 07 Feb 07 Mar 07 Apr 07May

07Jun 07

Labour Expense220,00

0220,00

0220,00

0242,00

0242,00

0242,00

0

Step 7: Estimate Electricity Expense.o Electricity expense is given as Rs 6 per unit. Hence, we need to ascertain

the units to be produced in each month (as shown in Step 5 above) and multiply them with cost of electricity per unit.

o Payment for electricity is to be made in the month following the month of production.

Dec 06 Jan 07 Feb 07 Mar 07 Apr 07May

07Jun 07

Production, units 6,000 8,000 10,000 12,000 14,000 14,000 16,000Cost Rs/unit 6 6 6 6 6 6 6Total Electricity Cost

36,000 48,000 60,000 72,000 84,000 84,000 96,000

Electricity Paid 36,000 48,000 60,000 72,000 84,000 84,000

Step 8: Estimate other expenses.o Plant maintenance, other production expenses and office administration

expenses are fixed and to be paid in the month incurred. These can be tabulated straight as given.

o Marketing expenses are given as 5% of month’s sales. Sales for each month were computed in Step 1 above. Marketing expenses will be simply 5% of that figure.

o Depreciation is a non-cash expense and does not appear in the cash budget.

o Hence, all other expenses can be tabulated as follows:

Jan 07 Feb 07 Mar 07 Apr 07May

07Jun 07

Plant Maintenance 80,000 80,000 80,000 80,000 80,000 80,000

Other Production Expenses120,00

0120,00

0120,00

0120,00

0120,00

0120,00

0

Office Administration Expenses350,00

0350,00

0350,00

0350,00

0350,00

0350,00

0Market & Dist. (5% of month’s sales revenue)

108,000

144,000

189,000

226,800

264,600

264,600

Step 9: Estimate other paymentso Repayment of long term loan is in two installments, of Rs 850,000 each, in

February and May 2007.o A new machine is to be bought in June 2007 for Rs 5,000,000. Since, we

will be showing the loan from Lease Company as receipt, we should show the entire cost of new machine as payment in the cash budget.

Jan 07 Feb 07 Mar 07 Apr 07May

07Jun 07

Long Term Loan repayment850,00

0850,00

0

Purchase of New Machine5,000,0

00

Step 10: Now arrange the above information in the form of Cash Budget and balance it.o Note that opening balance is given as Rs 100,000.o Our advice on payment of dividends or prior arrangements with bankers

will be based on balances of cash shown at the end of each month by the cash budget.

CASH BUDGETJan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

Receipts

Cash Sales (Step 3)216,00

0288,00

0378,000

453,600

529,200

5,29,200

60% of Last Month’s Credit Sales (Step 3)

1,166,400

1,166,400

1,555,200

2,041,200

2,449,440

2,854,680

38% of Prev to Last Month’s Cr Sales (Step 3)

984,960

738,720

738,720984,96

01,292,7

601,551,3

12

Total Collection for Sales (Step 3)2,367,3

602,193,1

202,671,9

203,479,7

604,271,4

004,938,1

92Rental Income (Step 4) 50,000 50,000

Lease Finance Loan (Step 4)3,500,0

00

Total Receipts2,367,

3602,193,

1202,721,

9203,479,

7604,271,

4008,488,

192

Payments

Raw Material (Step 5)840,00

01,120,0

001,400,0

001,680,0

001,960,0

002,058,0

00

Labour Expense (Step 6)220,00

0220,00

0220,000

242,000

242,000

242,000

Electricity Expense (Step 7) 36,000 48,000 60,000 72,000 84,000 84,000Plant Maintenance (Step 8) 80,000 80,000 80,000 80,000 80,000 80,000Other Production Expenses (Step 8)

120,000

120,000

120,000120,00

0120,00

0120,00

0

Office Admin Expenses (Step 8)350,00

0350,00

0350,000

350,000

350,000

350,000

Marketing & Distribution (Step 8)108,00

0144,00

0189,000

226,800

264,600

264,600

Long Term Loan Repayment (Step 9)

850,000

850,000

Purchase of New Machine (Step 9)

5,000,000

Total Payments1,818,

8003,018,

4002,532,

4002,906,

8804,109,

3608,357,

360

Balance for the month548,56

0(825,28

0)189,520

572,880

162,040

130,832

Balance brought forward100,00

0648,56

0(176,72

0)12,800

585,680

747,720

Balance carried forward648,56

0(176,72

0)12,800

585,680

747,720

878,552

Step 11: Advice to the Company.o Dividends cannot be paid in the first half of 2007 as the company does not

have a cash balance in excess of Rs 1,000,000 in any month.o The company will have a negative cash balance at the end of February

2007. Again, it will have less than the required minimum balance in March 2007. It must therefore make prior arrangements for an overdraft with its bankers for these two months. Alternatively, it may negotiate extended terms from creditors for these months.

KEY TERMS

o Transactional motiveo Precautionary motiveo Speculative motiveo Near Casho Potential Casho Cost of idle casho Cash operating cycleo Concentration bankingo Playing the floato Cash Budgetingo Budget periodo Discretionary receipts and paymentso Synchronization of receipts and payments

QUESTIONS

1. Discuss the reasons or motives for keeping cash. Which of these motives do you consider the most important? Why?

2. Explain the difference between the terms cash, near cash and potential cash, giving examples in each case.

3. What is meant by a cash management policy? What are the advantages of drawing up one?

4. Discuss the contents of a cash management policy of a small scale manufacturing company.

5. Discuss the statement, “The biggest problem of cash management is that cash is

the result of activities carried out by other persons, not the cash manager”. How do you propose this problem can be tackled?

6. What factors govern the level of cash to be maintained at any given time?

7. Discuss the methods of improving the cash inflows, clearly outlining the limitations of each method.

8. Discuss the methods of controlling or regulating cash outflows, clearly outlining the limitations of each method.

9. How may company handle cash surplus that are available for (a) a short period only (b) long term period?

10.

How may a company cope with cash short falls that are (a) short term or (b) long term in nature?

11.

What is meant by cash budgeting? Discuss the various factors that influence the process of cash budgeting.

12.

What is meant by (a) Budget Period (b) Budget Format

13.

Prepare a cash budget for Tightcash Private Ltd from the following information:

Estimated sales, purchases and expenses etc. are:All figures in millions of Rs.

May 07

& June 07July 07 Aug 07 Sept 07 Oct 07 Nov 07 Dec 07

Sales 350 400 400 500 550 600 650

Purchases 140 160 170 200 250 250 280

Wages and Salaries 120 140 140 180 158 200 220

Misc. Expenses 50 60 60 60 75 75 75

Rental Income 20 20

Issue of Shares 200

o 20% of sales are on cash and the rest on credit. Cash sales are allowed 1% cash discount.

o 50% of credit sales are collected in 30 days and 48% in 60 days. The rest are bad debts.

o Creditors for purchases are paid after 60 days. All other expenses are paid in the month they are incurred.

o A minimum cash balance of Rs 50 million is expected to be retained at all times. o A fixed asset costing Rs 30 million is to bought in any month that shows surplus

above the minimum balance.