Cash Management is one of the key areas of working capital management. It is the most liquid current assets. Other current assets also eventually get converted into cash.

Motives for Holding Cash

The cash with reference to cash management is used in two sense. The narrow sense of cash means, currency, cheques, drafts and demand deposits in banks. The broader view of cash includes near cash assets such as marketable securities and time deposits in banks because these can be readily sold and converted into cash.

Irrespective of the form in which cash is held, a distinguishing feature of cash is that it has no earning power. If cash does not earn any return, then why it is held?

Management of Cash and Marketable Securities

Motives for Holding Cash

There are four primary motives for maintaining cash balances:

i) Transaction motive ii) Precautionary motive iii) Speculative motive and iv) Compensating motive

i) Transaction Motive: Transaction motive refers to the maintaining cash balances (or near cash) to meet routine cash needs that occurs in the ordinary course of business. Such motive refers to the holding of cash to meet anticipated payments (cash outflows), whose timing is not perfectly synchronized with cash receipts (inflows). If the timing of cash receipts and cash disbursements (payments) could exactly coincide in the normal course of operations, a firm would not need cash for transaction purposes. Although a major part of transaction balances are held in cash, a part may also be kept as marketable securities whose maturity conforms to the timing of the anticipated payments, such as payment of taxes, dividends and so on.

ii) Precautionary Motive: In addition to the non-synchronization of anticipated cash inflows and cash outflows in the ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted or anticipated. The unexpected cash needs at short notice may be the result of:

Floods, strikes, or failure of important customers.

Bills may be presented for settlement earlier than expected.

Unexpected slow down in collection of accounts receivables.

Sharp increase in cost of raw materials.

Thus, precautionary motive refers to holding of precautionary cash balance (or near cash) to meet unpredictable obligations arising from unexpected contingencies. Another factor which impacts maintenance of such cash balance is the availability of short-term credit. If a firm can borrow at short notice pay for unexpected obligations, it will need to maintain a relatively small precautionary cash balance and vice versa.

iii) Speculative Motive: Speculative motive refers to holding cash balances (or near cash) to take advantage of the opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. Firms aim to exploit profitable opportunities and keep cash in reserve to do so.

The speculative motive helps to take advantage of:

An opportunity to purchase raw materials at reduced price on payment of immediate cash

Delay purchases of raw materials on the anticipation of declines in prices

A chance to speculate on interest rate movements by buying securities when interest rates are expected to decline.

iv) Compensating Motive: Compensating motive refers to holding of cash or near cash to compensate banks for providing certain services or loans. Some banks charge commission or fee, some seek indirect compensation in the form of maintaining a minimum balance of cash at the bank. This balance cannot be utilized by the firm for transaction purposes, the bank themselves can use the amount to earn a return. Such balances are compensating balances. Compensating balances are also required by some loan agreements between a bank and its customers.

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Of the four motives of holding cash (near-cash) balances, the two most important are the transaction motive and compensating motive. Business firms normally do not speculate and need not have speculative balances. The requirement of precautionary balances can be met out of short-term borrowings.

Objectives of Cash Management

The objectives of cash management are two-folds:

i) To meet the payment schedule

ii) To minimize funds committed to cash balances

i) Meeting Payment Schedule: Firms have to make payment of cash on a continuous and regular basis to suppliers of goods, employees and so on. The firm must have sufficient cash to meet the cash disbursement needs of a firm. The advantage of having sufficient cash to meet the payment schedule are:

a) It prevents insolvency or bankruptcy arising out of the inability of a firm to meet its obligations. (b) the relationship with the bank is not strained (c) it helps in fostering good relations with trade creditors and suppliers of raw materials, as prompt payment may help their own cash management (d) cash discount can be availed of, if payment is made within the due date (e) it leads to stronger 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 (f) to take advantage of favorable business opportunities that may be available periodically.

ii) Minimizing Funds Committed to Cash Balances: A high cash balance will ensure liquidity but as cash in a non-earning asset, the firm will have to forego profits. A low cash balance will mean failure to meet payment schedule. The aim of cash management is to have an optimal amount of cash balances.

Determining Cash Need

There are two approached to derive an optimal cash balance

i) Minimizing Cost Cash Models

ii) Cash Budget

i) Cash Management / Conversion Models:

While it is true that financial managers not necessarily follow cash management models exactly to manage firm’s cash but understanding of these models provides an insight into how cash management should be conducted. One of the analytical model of cash management is ‘Baumol Model’.

The target / optimal cash balance involves a trade-off between the opportunity cost of holding too much cash (the carrying cost) and the costs of holding too little cash (the shortage costs, also called adjustment costs).

The BAT (Baumol-Allias-Tobin) Model: Determining the Optimum Cash Balance Under Certainty

The Baumol (BAT) cash management model provides a formal approach for determining a firm’s optimum cash balance under certainty. According to Baumol model, the firm tries to minimize the sum of the cost of holding cash (opportunity cost) and the cost of converting marketable securities into cash (trading cost).

The Baumol model makes the following assumptions:-

The firm is able to forecast its cash needs with certainty.The firm’s cash payments occur uniformly over a period of time.The opportunity cost of holding cash is known and it does not change over time.The firm will incur the same trading cost whenever it converts marketable securities to cash.

Baumo Model: Let us assume that the firm sells securities and starts with a cash balance of C taka. As the firm spends cash, its cash balance decreases steadily and reaches to zero. The firm replenishes it cash balance to C taka by selling marketable securities. This pattern continues over time. Since the cash balance decreases steadily, the average cash balance will be: C/2. This pattern is shown in the following figure:

Baumol Model:The firm incurs a opportunity cost of holding cash which is the return forgone on the marketable securities. If the opportunity cost or the return forgone is denoted by R. Hence, the total opportunity cost of cash balance is:Opportunity Cost = (C/ 2) X R

The firm incurs a trading cost, whenever it converts its marketable securities to cash. Total number of trading during the year will be the total fund disbursement during the year (T), divided by the cash balance (C), i.e. T/C . The per transaction cost or trading cost is assumed to be constant. If per transaction cost is F, the total trading cost will be:Trading Cost = (T/ C) X F

The total annual cost of the cash balance will be: Total Cost = Opportunity Cost + Trading Cost =(C/ 2) X R + (T/ C) X F

Baumol Model:

It is known that the opportunity cost (holding cost) increases as cash balance, C, increases. However, the trading cost reduces, because with increasing C, the number of trading will decline. Thus, there is a trade-off between the opportunity cost and the trading cost which is depicted in the following figure.

Figure: Cost trade-off: Baumol Model

In the figure, the optimum cash balance C* is obtained when the total cost (sum of opportunity cost and trading cost) is minimum.

The formula to obtain optimum cash balance in Baumol model is as follows:

C* = √(2T X F) / R

Here, C* is the optimum cash balance, F is the cost per trading of marketable securities, T is total amount of cash disbursement needed during the year, and R is the opportunity cost of holding cash balance.

The optimum cash balance will increase with the increase in the per trading cost (F) and total funds disbursement (T) and will decrease with the increase in opportunity cost (R).

QS 1: Advani Chemical Ltd estimates it total cash requirements as Taka 2 crore next year. The company’s opportunity cost of fund is 15% per annum. The company will have to incur Taka 150 per transaction, when it converts its short-term securities to cash. Determine the optimum cash balance using the BAT model. How much is the total annual cost of the demand for the optimum cash balance? How many deposits has to be made during the year.Solution-1: Given, annual cash disbursement, T = TK 20,000,000 Return forgone is, R = 15% Fixed cost per trading, F = 150Optimum Cash Balance: C* = √(2T X F) / R C* = √(2 X 20,000,000 X 150) / 0.15 =TK 2,00,000Opportunity cost = (C/2) X R = (TK 2,00,000 /2) X 0.15 = TK15,000Trading Cost = (T/C) X F = (TK 20,000,000 / TK 2,00,000) X 150= TK 15,000Total Cost= Opportunity Cost + Trading cost = TK 15,000+ TK 15,000 = TK 30,000Number of deposits to be made during the year is : T/C = (TK 20,000,000 / TK 2,00,000) = 100 times per year

QS-2: The Vulcan Corporation has cash outflows of $100 per day, seven days a week. The interest rate is 5% and the fixed cost of replenishing cash balances is $10 per transaction. What is the optimum initial cash balance, use BAT model? What is the total cost? How many times cash is replenished per year? After how many days cash is replenished?Solution-2 Given, annual cash disbursement, T = $ 100 per day X 365 days = $36,500Return forgone is, R = 5%; Fixed cost per trading, F = $10Optimum Cash Balance: C* = √(2T X F) / R C* = √(2 X $36,500 X 10) / 0.5 =$ 3821Opportunity cost = (C/2) X R = ($ 3821 /2) X 0.5 =$1911 X 0.5=$ 96Trading Cost = (T/C) X F = ($36,500 / $ 3821) X $10= 9.6 times X $10 =$96Total Cost = Opportunity Cost + Trading Cost = $96 + $96 = $192Cash is replenished per year =T/C= ($36,500 / $ 3821) = 9.6 timesCash is replenished after how many days:The Vulcan Corporation has cash outflows of $100 per day, hence the initial cash balance C will last for = $3821 / $100 per day = 38.21 days. That is, after 38 days (approximately )the cash balance has to be replenished.OR: The firm needs to re-supply the account: 365 days / 9.6 time = 38 days (approximately).

Solution-3: Here, interest rate, R = 12%, Fixed order cost, F =$100,Total cash disbursement, T =$2,40,000Optimum Cash Balance: C* = √(2T X F) / R C* = √(2 X $2,40,000 X 100) / 0.12 =$ 20,000Opportunity cost = (C/2) X R = ($ 20,000 /2) X 0.12 =$10,000 X 0.12=$ 1200Trading Cost = (T/C) X F = ($2,40,000 / $20,000) X $100= 12 times X $100 =$1200Total Cost = Opportunity Cost + Trading Cost = $1200 + $1200 = $2400

If $15,000 cash balance were held:Opportunity cost = (C/2) X R = ($ 15,000 /2) X 0.12 =$7500 X 0.12=$ 900Trading Cost = (T/C) X F = ($2,40,000 / $15,000) X $100= 16 times X $100 =$1600Total Cost = Opportunity Cost + Trading Cost = $900 + $1600 = $2500

QS-3: Given the following information, calculate the target cash balance using the BAT model:

What are the opportunity cost of holding cash, the trading cost, and the total cost? What would these be if $15,000 cash balance were held instead?

QS-4: White Whale Corporation has an average daily cash balance of $300. Total cash needed for the year is $30,000. The interest rate is 5% and replenishing the cash cost $6 each time. What are the opportunity cost of holding cash, the trading cost, and the total cost? What do you think of White Whale’s Strategy?Solution-4:Here, interest rate, R = 5% Fixed order cost, F =$6 Total cash disbursement, T =$30,000

Average daily cash balance : C/2 = $300, Hence, daily cash balance, C = $600Opportunity cost = (C/2) X R = ($ 600 /2) X 0.05 =$300 X 0.05 =$ 15Trading Cost = (T/C) X F = ($30,000 / $600) X $6 = 50 times X $6 =$300Total Cost = Opportunity Cost + Trading Cost = $15 + $300

= $315

QS:5: The annual cash requirement of A Ltd. is Tk 10 lakh. The company has marketable securities in lot sizes of Tk 50,000, Tk 1,00,000, Tk 2,00,000, Tk 2,50,000 and Tk 500,000. Cost of conversion of marketable securities per lot is Tk 1000. The company can earn 5% yield on its securities. You are required to prepare a table indicating which lot size is economic/optimum and will be sold by the company? Also show the economic/optimum lot size can be obtained by the Baumol Model?

SOLUTION:5

Optimum or economic lot size is TK 2,00,000 because at this size the total cost is minimum.

b) Here, interest rate, R = 0.05% Fixed trading cost, F =1000 Total cash disbursement, T =10,00,000According to Bumol Model,Optimum Cash Balance (economic lot size): C* = √(2T X F) / R = √(2 X 10,00,000 X 1000) / 0.05 = TK 2,00,000

QS:6: The ABC ltd requires TK 30 lakh in cash to meet its transaction needs during the next three-month cash planning period. It holds marketable securities of an equal amount. The annual yield on these marketable securities is 20%. The conversion of these securities into cash entails a fixed cost of TK 3000 per transaction. Assuming ABC ltd can sell its marketable securities in any of the five lost sizes: tk 1,50,000, tk 3,00,000, tk tk 6,00,000, tk 7,50,000, and tk 15,00,000.

You are required to prepare a table indicating which lot size is economic and will be sold by the company? Also show the economic/optimum lot size can be obtained by the Baumol Model?

Cash Budget

Cash budget is the most important tool in cash management. It a device to help a firm to plan and control the use of cash.

Cash budget is a statement showing estimated cash inflows and cash outflows over the planning horizon. In other words, it is used to estimate the short term cash requirements of the firm.

The various purposes of cash budget are:

i) To coordinate the timings of cash needs. It identifies the period of surplus or deficit. (ii) it enables a firm which has sufficient cash to take advantage of cash discounts on its accounts payable, to pay obligation when due, to formulate dividend policy, to plan financing of capital expansion and to help unify the production schedule during the year so that the firm can smooth out costly seasonal fluctuations (iii) it helps to arrange needed funds on the most favorable terms and prevent the accumulation of excess funds.

Cash budget gives financial manager adequate time to study the firm’s cash needs, thus the manager can select the best alternative for meeting the need. In contrast, a firm which does not budget its cash requirement , may suddenly find itself short of cash. With pressing needs and little time to explore alternative avenues / sources of financing, hence the management would be forced to accept the terms offered by the lender.

Net Cash Position (Surplus or deficit)

= Estimated Cash Inflow – Estimated Cash Outflow

Cash Inflow from Operating Activities:

i) Cash sales (ii) Collection of accounts receivables

ii) Disposal of fixed assets

Cash Outflow from Operations:

i) Account payable / payable payments

ii) Purchase of raw materials

iii) Wages and salary (payroll)

iv) Factory expenses

v) Administrative and selling expenses

vi) Maintenance expenses

vii) Purchase of fixed assets

NOTE THAT: Depreciation is non-cash expense, hence it is not considered as a cash outflow

Cash inflow from financial activity:

i) Loans and borrowings (ii) sales of securities

(iii) interest received (iv) dividend received

(v) refund of tax (vi) issue of new shares and securities.

Cash outflow from financial activity:

i) Income tax / tax payments

ii) Redemption or repayment of loan

iii) Repurchase of shares

iv) Interest paid

v) Dividends paid

QS1: The following data pertain to a shop. The owner has made the following sales forecast for the first 5 months of the coming year:

January TK 40,000 April TK 60,000

February TK 45,000 May TK 50,000

March TK 55,000

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Other data are as follows: a) Debtors and creditors balances at the beginning of the year are Tk 30,000 and Tk 14,000 respectively. The opening balances of other relevant assets and liabilities are:

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Cash balance Tk 7,500

Stock Tk 51,000

Accrued sales commission Tk 3,500

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b) 40% of sales are on cash basis. Credit sales are collected in the month following sale.

(d) The only variable cost is a 5% commission to sales agents. The sales commission is paid in month after it is earned.

(e) Trade Creditors are paid in the following month after purchases.

The expected purchases for the coming year are:

January TK 33,000 ; February TK 36,000 ;March TK 30,0000, April TK 32,000

(f) Fixed costs are Tk 5000 per month, including Tk 2000 depreciation.

You are required to prepare a cash budget for each of the first three months of coming year.

SOLUTION:1

QS; 2: The following results are expected by XYZ ltd by quarters in thousands of Taka.

The debtors collected at the end of a quarter are one-third of sales of the previous quarter. The opening balance of debtor is TK 30,00,000. Cash at the beginning of the year is TK 6,50,000 and the desired minimum cash balance is Tk 5,00,000. Borrowings are made at the beginning of quarters in which the need will occur and are repaid at the end of quarters when there is surplus. Interest charges are ignored. Prepare:

i) a cash budget by quarters for the year and

ii) State the amount of loan outstanding at the end of the year.

SOLUTION:2

b) Loan Outstanding = Tk 35,50– Tk 33,00,

= TK 2,50