chapter27 cash and_liquidity_management

Chapter 27

CASH AND LIQUIDITY MANAGEMENT

Centre for Financial Management , Bangalore

OUTLINE

• Motives for Holding Cash

• Cash Budgeting

• Long-term Cash Forecasting

• Reports for Control

• Cash Collection and Disbursement

• Optimal Cash Balance

• Investment of Surplus Funds

• Cash Management Models Centre for Financial Management , Bangalore

MOTIVES FOR HOLDING CASH

Keynes identified three possible motives for holding cash :

• Transaction motive

• Precautionary motive

• Speculative motive


CASH BUDGETThe principal method of cash budgeting is the receipts and disbursements method. Under this method, the cash forecast shows the timing and magnitude of cash receipts and disbursements over the forecast period.

Illustration

The following information about Beta Company is given:

• The estimated sales for the period January 20X1 through June 20X1 are as follows: Rs.100,000 a month from January through March and Rs.120,000 a month from April through June.

• The sales for November and December of the previous year have been Rs.100,000 each.

• Cash and credit sales are expected to be 20 percent and 80 percent respectively.

• The receivables from credit sales are expected to be collected as follows: 50 percent after one month and the balance 50 percent after two months.

• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March and Rs.2000 interest on securities in June. Centre for Financial Management , Bangalore

CASH BUDGETING

January February March April May June

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

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

3. Collection of accounts receivables 80,000 80,000 80,000 80,000 88,000 96,000

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

5. Receipt from machine sale 5,000

6. Interest 2,000 Total cash receipts 100,000 100,000 105,000 104,000 112,000 122,000

(3+4+5+6)


CASH BUDGETINGRelevant information for cash payments

• Beta Company plans to purchase materials worth Rs.40,000 in January and February and materials worth Rs.48,000 each month from March through June. Payments will be made a month after the purchase

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

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

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

• Payments for manufacturing expenses will be Rs.20,000 per month and for general administrative expenses will be Rs.10,000 per month, January through June

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

• A machine will be bought in cash for Rs. 50,000 in March Centre for Financial Management , Bangalore

CASH BUDGETING

January February March April May June

1. Material purchases 40,000 40,000 48,000 48,000 48,000 48,000 2. Credit material purchases 40,000 40,000 48,000 48,000 48,000 48,000 3. Payment of 40,000 40,000 40,000 48,000 48,000 48,000 accounts payable 4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000 cash purchases 5. Wages 15,000 15,000 15,000 15,000 15,000 15,000 6. Manufacturing exp. 20,000 20,000 20,000 20,000 20,000 20,000 7. General admn. expense 10,000 10,000 10,000 10,000 10,000 10,000 8. Dividend - - - - - 20,000 9. Tax - - - - - 20,00010. Capital - - 50,000 - - - expenditure Total payments 87,000 87,000 137,000 95,000 95,000 135,000 (3+4+5+6+7+8+9+10)


CASH BUDGETINGAssuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balancerequired by the firm is Rs.20,000, the summary cash forecast is given below.

January February March April May June 1. Opening cash balance Rs.22,000

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

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

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

5. Cumulative net cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000

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

7. Minimum cash balance required 20,000 20,000 20,000 20,000 20,000 20,000

8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000 relation to the minimum cash balance required (6 – 7)


LONG-TERM CASH FORECASTING

Adjusted net income method is generally used for long-term cash forecasting.

20 X 0 20 X 1 20 X 2 20 X 3 20 X 4 Source Net income after taxes Non-cash charges (Depreciation, amortisation, etc.)

Increase in borrowings Sale of equity shares Miscellaneous Uses Capital expenditures Increase in current assets Repayment of borrowings Dividend payment Miscellaneous Surplus/ Deficit Opening cash balance Closing cash balance

REPORTS FOR CONTROL

• Daily Cash Report

• Daily Treasury Report

• Monthly Cash Report


CASH COLLECTION AND DISBURSEMENT

• Float

• Speeding up Collections

• Delaying Payments

• EDI : Will the Float Disappear


FLOAT

• The cash balance shown by a firm on its books is called

the book, or ledger, balance whereas the balance shown

in its bank account is called the available, or collected,

balance. The difference between the available balance

and the ledger balance is referred to as float.

• There are two kinds of float viz., disbursement float and

payment float


OPTIMAL CASH BALANCE

•

C*

Costs

Total costs

Opportunity cost

Transaction cost

Cash balance


INVESTMENT OF SURPLUS FUNDS

It may be useful to divide a firm’s short-term investment portfolio into three segments:

• Ready cash segment

• Controllable cash segment

• Free cash segment


CRITERIA FOR EVALUATING

INVESTMENT OPTIONS

• Safety

• Liquidity

• Yield

• Maturity


INVESTMENT OPTIONS

• Fixed deposits with banks

• Treasury bills

• Mutual fund schemes

• Money market schemes

• Commercial paper

• Certificates of deposit

• Inter-corporate deposits

• Ready forwards

• Bill discounting


CASH MANAGEMENT MODELS

Several cash management models have addressed this issue

of split between marketable securities and cash holdings.

Two such models are :

• Baumol model

• Miller and Orr model


BAUMOL MODEL

2bT C = I

where: C = amount of marketable securities converted into cash per order

I = interest rate per planning period on investment in marketable securities.

T = Projected cash requirements during the planning period


MILLER AND ORR MODEL

3bσ 2

RP = 3 + LL 4I

UL = 3RP – 2LL

where: RP = return point

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

I = daily interest rate earned on marketable securities

σ 2 = variance of daily changes in the expected cash balance

LL = the lower control limit

UL = the upper control limit


SUMMING UP

• There are three possible motives for holding cash, viz., transaction motive, precautionary motive, and speculative motive.

• The principal method of short-term cash forecasting is the receipts and payment method.

• The method generally used for long-term forecasting is the adjusted income method.

• To enhance the efficiency of cash management collections and disbursements must be properly monitored.

• A variety of options are there for investing surplus funds available for short periods.

• William Baumol has proposed a model which applies the EOQ concept to determine the cash conversion size.

• Expanding on the Baumol model, Miller and Orr consider a stochastic generating process for periodic changes in cash balance.


chapter27 cash and_liquidity_management

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