MANAGEMENT OF CASHDefine CashIn common language and narrow sense cash refers to money in the physical form of currency, such as banknotes and coins.For accounting and finance purposes and broader sense, cash includes money in hand, petty cash, bank account balance, customer-cheques, and marketable securities. Thus it also includes near cash assets such as marketable securities and time deposits with banks. Such securities or deposits can be sold or converted into cash if circumstances arise.

Motives of Holding Cash1. Transaction motive: Firms maintain cash balances to conduct normal and routine

business transactions. For example,• salaries/wages• Supplies and inventory purchases • Trade discounts• Other day-to-day expenses of being in business such as taxes, interest,

dividends etc2. Precautionary motive: Holding up of cash balance in order to take care of

contingencies and unforeseen circumstances is known as precautionary motive. In addition to requirement of cash for regular transactions, the company may require the cash for such purposes which cannot be estimated or foreseen. For example: Sudden decline in the collection from the customers or sharp increase in the prices of raw materials may put the company in such a situation where they need additional funds to deal with such situation without affecting its regular business.

3. Speculative motive: Firms maintain cash balances in order to “speculate” – that is, to take advantage of unanticipated business opportunities that may come along from time to time. The nature of these opportunities may vary. For example: If the company presumes that in near future prices of raw material is going to be low, then it will preserve that cash for future purchase of raw material. In another case if interest rates are expected to increase then the company will purchase securities from the reserved cash.

4. Compensation motive: Banks provide certain services to their clients free of charge. They, therefore require clients to keep minimum balance with them, which helps bank earn interest and thus compensate them for free services so provided. Further, firms using bank debt are required to maintain a compensating balance with the bank from which they have borrowed the money.Compensating balance: when a bank makes a loan to a firm, the bank requires this minimum balance in a non-interest-earning checking account equal to a specified percentage of the amount borrowed

1. Common arrangement is a compensating balance equal to 5-10% of amount of loan

2. Bankers maintain that existence of compensating balance prevents firms from overextending cash flow position because it forces them to maintain a reasonable minimum cash balance.

Cash ManagementIt is the corporate process of collecting, managing and (short-term) investing cash. Cash management is the key component of ensuring a company's financial stability and solvency. Cash management is a broad term that refers to the collection, concentration, and disbursement of cash. It encompasses a company's level of liquidity, its management of cash

balance, and its short-term investment strategies. In some ways, managing cash flow is the most important job of business managers. If at any time a company fails to pay an obligation when it is due because of the lack of cash, the company is insolvent. Insolvency is the primary reason firms go bankrupt. Obviously, the prospect of such a dire consequence should compel companies to manage their cash with care. Moreover, efficient cash management means more than just preventing bankruptcy. It improves the profitability and reduces the risk to which the firm is exposed.

Objectives of Cash Management1. Meeting the Cash Disbursements: The firm should have enough cash to meet the

various requirements of the firm at different period of times. Eg purchase of raw material, wages etc.

2. Maintaining Optimum Cash Balance: to avoid situation of excessive and inadequate cash and to determine and maintain the level of cash after achieving a trade off between the profitability and liquidity so as to maximise the wealth of shareholders.

Problems of Cash Management1. Controlling levels of cash : This involves :

a. Preparing cash budget- Cash budget is an estimation of the cash inflows and outflows for a business or individual for a specific period of time. Cash budgets are often used to assess whether the entity has sufficient cash to fulfil regular operations and/or whether too much cash is being left in unproductive capacities.

b. Providing for unpredictable discrepancies-Cash budget does not predicts discrepancies between cash inflows and outflows due to unpredictable events like strikes, recessions and natural calamities etc. A certain minimum amount of cash balance has to be kept for meeting such unforeseen events.

c. Consideration of short costs- these are the costs incurred as a result of shortage of cash such as

The failure of the firm to meet its obligations in time may result in legal action by the firms creditors.

Borrowing may have to be resorted to at higher interest rates.

Cash Management ModelsThe main objective of cash management is an optimal cash balance; minimizing the sum of fixed cost of transactions and the opportunity cost of holding cash balance. Optimal balance here means a position when the cash balance amount is on the most ideal proportion so that the company has the ability to invest the excess cash for a return [profit] and at the same time have sufficient liquidity for future needs.The key ingredient here is that the cash balance should neither be excessive nor deficient.The question is; how to determine the optimal cash balance? William Baumol and Miller-Orr offer cash models to determine the optimal cash balance that you can use.

1. Baumol Model (Determining Optimal Cash Balance Under Conditions of Certainty)

William J. Baumol developed this model which helps in determining a firm's optimum cash balance under certainty. It is extensively used and highly useful for the purpose of cash management. The Baumol Cash Management Model is deterministic in that it assumes that the firm's demand for cash over the relevant time period is known with certainty. This model

trades off between opportunity cost or carrying cost or holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding cash & the cost of converting marketable securities to cash. Thus, Optimum cash level is one where opportunity cost or carrying cost or holding cost & the transaction cost are equal and total cost is minimum.

As per the model, cash and inventory management problems are one and the same.

Assumptions: There are certain assumptions that are made in the model.

1. The firm is able to forecast its cash requirements with certainty and receive a specific amount at regular intervals.2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate of cash outflows.3. The opportunity cost of holding cash is known and does not change over time. Cash holdings incur an opportunity cost in the form of opportunity foregone.4. The firm will incur the same transaction cost whenever it converts securities to cash. Each transaction incurs a fixed and variable cost.

For example, let us assume that the firm sells securities and starts with a cash balance of C rupees. When the firm spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its money by selling marketable securities. As the cash balance decreases gradually, the average cash balance will be: C/2. This can be shown in following figure:

Carrying/Holding cost: The firm incurs a cost known as holding cost for maintaining the cash balance. It is known as opportunity cost, the return inevitable on the marketable securities. If the opportunity cost is k, then the firm’s holding cost for maintaining an average cash balance is as follows:

Holding cost = k (C/2)

Transaction cost: Whenever the firm converts its marketable securities to cash, it incurs a cost known as transaction cost. Total number of transactions in a particular year will be total funds required (T), divided by the average cash balance (C) i.e. T/C. The assumption here is

that the cost per transaction is constant. If the cost per transaction is c, then the total transaction cost will be:

Transaction cost = c (T/C)

Total cost = k (C/2) + c (T/C)

Optimum level of cash balance

As the demand for cash, ‘C’ increases, the holding cost will also increase and the transaction cost will reduce because of a decline in the number of transactions. Hence, it can be said that there is a direct relationship between the holding cost and an inverse relationship between the transaction cost. With the increase in the cost per transaction and total funds required, the optimum cash balance will increase. However, with an increase in the opportunity cost, it will decrease.

The optimum cash balance, C* is obtained when the total cost is minimum.

C*= Ö [(2T*c)/k]

Where, C* is the optimum cash balance.T is the total cash needed during the year.c is fixed cost per transactionk is the opportunity cost of holding cash balances.

Limitations of the Baumol’s model:

1. It does not allow cash flows to fluctuate.2. Overdraft is not considered.3. There are uncertainties in the pattern of future cash flows.

Illustration: Monthly cash requirement = Rs 60000 Fixed cost = Rs 10 Interest = 6% p.a. Find the Optimum Cash Balance.

Miller- Orr Model: (Determining Optimal Cash Balance Under Conditions of Uncertainty)

This model helps the present day companies to manage their cash while taking into consideration the fluctuations in daily cash flow. The purpose is to satisfy cash requirements at the least cost. A major assumption is the randomness of cash flows.

It is a stochastic model for cash management where uncertainty exists for cash flows. The Miller-Orr model places an upper and lower limit for cash balances. Use of the Miller-Orr Model requires that the firm establish minimum and maximum acceptable cash balances and appropriate levels of securities for the firm to sell or purchase when these levels are reached.

The model further assumes that the firm is able to obtain cash from revenues, but this source of cash may not be sufficient to cover the firm's needs for cash. Therefore, the firm must liquidate securities to obtain cash when revenues are insufficient to cover the firm's cash needs. Because the firm has only limited control over the magnitude and timing of its revenues, it may find its cash balances rising to unacceptably high levels. When the firm's cash balances are too high, it forgoes too much interest and must purchase securities to dispose of the surplus cash .Thus, when the upper limit is reached, a transfer of cash to marketable securities is made. When the lower limit is reached, a transfer from securities to cash occurs. A transaction will not occur as long as the cash balance falls within the limits.

Description of the Miller and Orr Model of Cash Management

Miller-Orr model helps in determining the optimum level of cash in such circumstances. It deals with cash management problem under the assumption of stochastic or random cash flows by laying down control limits for cash balances. These limits consist of anupper limit (h), lower limit (o) and return point (z). When cash balance reaches the upper limit, a transfer of cash equal to “h-z” is affected to marketable securities. When it touches the lower limit, a transfer equal to “z-o” from marketable securities to cash is made. No transaction between cash to marketable securities and marketable securities to cash is made during the period when the cash balance stays between the high and low limits.

The above chart shows that when cash balances reaches the upper limit, an account equal to “h-z” is invested in the marketable securities and cash balance comes down to “z” level. When cash balance touches the lower limit marketable securities of the value of “z-o” are sold and the cash balance again goes up to ‘z’ level. The upper limit and lower limit are set on the basis of opportunity cost of holding cash; degree of likely fluctuation in cash balances and the fixed costs associated with securities transactions.

The Miller-Orr cash model takes into account the fixed costs of a securities transaction (F), which is assumed to be the same for buying as well as selling, the daily interest rate on marketable securities (i), and the variance of daily net cash flows [v].

The optimal cash balance “z” is computed as:

The average cash balance will approximate (z + h)/3

Case Example

You wish to use the Miller-Orr model. The following information is supplied:

Fixed cost of a securities transaction = $10 Variance of daily net cash flows = $50 Daily interest rate on securities (10%/360) = 0.0003

The optimal cash balance, the upper limit of cash needed, and the average cash balance are:

The optimal cash balance is = $102.

The upper limit is = $306 [=3 × $102].

The average cash balance is: $136 = ($102 + $306)/3

A brief elaboration on these findings is needed for clarification. When the upper limit of $306 is reached, $204 of securities ($306–$102) will be purchased to bring you to the optimal cash balance of $102. When the lower limit of zero dollars is reached, $102 of securities will be sold to again bring you to the optimal cash balance of $102.

And the cash model is shown below: