MANAGEMENT OF CASHMANAGEMENT OF CASH

1. Importance of Cash1. Importance of CashWhen planning the short or long-term When planning the short or long-term funding requirements of a business, it is funding requirements of a business, it is more important to forecast the likely cash more important to forecast the likely cash requirements than to project profitability requirements than to project profitability etc. etc.

Bear in mind that more businesses fail Bear in mind that more businesses fail for lack of cash than for want of profit.for lack of cash than for want of profit.

• Important because: 1. Liquid 2. Used for immediate payments

• Insufficient (discharging its liabilities)• Extreme (uneconomic investments)

• Count cash in the form of currency , cheque, drafts, D.D s.

• Also includes marketable securities, short term, deposits with the banks.

Motives / purposes for holding cash

1. Transaction motive

2. Precautionary motive

3. Speculative motive

4. Compensation motive

2. Cash vs Profit2. Cash vs Profit

Sales and costs and, therefore, profits do not Sales and costs and, therefore, profits do not necessarily coincide with their associated cash necessarily coincide with their associated cash inflows and outflows.inflows and outflows.

The net result is that cash receipts often lag cash The net result is that cash receipts often lag cash payments and, whilst profits may be reported, the payments and, whilst profits may be reported, the business may experience a short-term cash shortfall. business may experience a short-term cash shortfall.

For this reason it is essential to forecast cash For this reason it is essential to forecast cash flows as well as project likely profits.flows as well as project likely profits.

Income Statement:Income Statement: Month 1Month 1

Sales ($000)Sales ($000) 7575

Costs ($000)Costs ($000) 6565

Profit ($000)Profit ($000) 1010

CFs relating to Month 1:CFs relating to Month 1:Amount in ($000)Amount in ($000)

Month 1Month 1 Month 2Month 2 Month 3Month 3 TotalTotal

Receipts from salesReceipts from sales 2020 3535 2020 7575

Payments to suppliers etc. Payments to suppliers etc. 4040 2020 55 6565

Net cash flowNet cash flow (20)(20) 1515 1515 1010

Cumulative net cash flowCumulative net cash flow(20)(20) (5)(5) 1010 1010

Objectives of cash management

Ensure that a firm should have right quantity and right quality from the right sources at a right place and at a right time.

• Meeting the cash outflows (meet the obligations): sufficient cash to make the payments schedule and disbursements. It will help in : A. avoiding the chances of default. B. availing the opportunities of getting cash discounts by making prompt payments. C. meeting expected cash outflows without much problem.

• Minimizing the cash balance : A. Idle cash balance must be reduced.

FACTORS AFFECTING CASH NEEDS

1. Cash cycle : refers to the time between the payments for purchase for purchase of raw materials & receipts of sales revenue.

2. Cash inflows and cash outflows: Cash balance is required to fill up the gap arising out of difference in timings & quantum of inflows and outflows. If the inflows are appearing just at the time when cash is required for payment, then no cash balance is required to be maintained by the firm, but this seldom happens. Thus, there should be synchronization between cash inflows and cash outflows.

3. Cost of cash balance: cost of maintaining excess cash balance or to meet the shortages of cash.

4. Other considerations: uncertainties of certain trade, staff required for cash management

Operating cycle and Cash cycle

Payable Deferral period

Inventory conversionperiod

Cash conversioncycle

Operating cycle

Pay forResourcespurchases

Receive Cash

Purchaseresources

SellProductOn credit

Receivable Conversion period

CASH MANAGEMENT STRATEGIESCASH MANAGEMENT STRATEGIES

1. Cash planning2. Cash forecasts and budgeting

Receipts and Disbursements Method Adjusted Net Receipts and Disbursements Method Adjusted Net Income Method (Sources and Uses of Cash)Income Method (Sources and Uses of Cash)

3.3. Managing cash flowsManaging cash flows a. methods of accelerating cash inflows b. method of slowing cash outflows

Methods of accelerating cash inflows

1. Prompt payments by customers

2. Quick conversion of payment into cash

3. Decentralized collections (Concentration)

4. Lock box system

Speed up collections

Customer mailing company company cash

The cheque receives the deposits available

cheque the cheque

Time

mailing processing availability

time delay

Float

Cash inflows can be improved by cash collecting process.

1. Postal float: mailing time i.e. time taken by post office for transferring cheque from customers to the firm.

2. Lethargy: time taken in processing the cheque within the organization and sending it to bank for collection.

3. Bank float: collection time within the bank i.e. time taken by the bank for collecting the payment from the customer s’ bank. Deposit float = postal + lethargy + bank

Lock box system

1. Under this system, customers are advised to mail their payments to special post office boxes , called lock boxes which are attending by the local collecting banks, instead of sending them to corporate H.Q.

2. Local banks collects the cheque once or more a day from the lock box, deposits the cheque directly into the local bank a/c of the firm & gives the details to the firm.

3. Helps in: A. cuts down the mailing time as the cheque are received at a nearby P.O. instead of H.Q. B. reduces the processing time as the company does not have to open the envelopes & deposits the cheque for collection. C. shorten the availability delay as the cheque are typically drawn on local banks.

Float

Cash balance shown by the firm on its books is called book / ledger balance.

Balance shown in its bank account is called available / collected balance.

Difference between the available balance and the ledgers balance is referred as float

• Disbursement float: cheque issued by a firm create disbursement float.

• Collection float : Cheque received by a firm lead to collection float.

Collection float

• A company has a book balance as well as available balance of Rs. 5 million as on 30th April. On 1st may , company receives a cheque for 1.5 million.

However, this amount is not available to a company until its bank presents the cheque to the customers bank’s and suppose it will present on 5th May.

Collection Float= Available balance – Book balance

= 5 million – 6.5 million

Disbursement Float

• A company has a book balance as well as available balance of Rs. 4 million with its bank , SBI, as on March 31st.

On 1st April , firm pays Rs. 1 million by cheque to one of its supplier & reduce the book balance by Rs. 1 million.

SBI, however, will not debit the company till the cheque has been presented for payment and it is presented on 6th April.

Hence between 1st April & 6th April , Disbursement float = 1 million

Disbursement float = firms’ available balance – firms’ book balance.

Net Float = disbursement float + collection Float

Positive = available balance is greater then the book balance

Negative = available balance is less than the book balance

Slow down - payments

1. Paying on last date

2. Payment through drafts

3. Centralized collections

4. Making use of float (Disbursement)

Investment alternatives

1. Marketable securities

2. Treasury bills

3. Certificates of deposits

4. Commercial papers

5. Repo agreements

(Money market instruments)

W.J.BAUMOL Model

• It is same as E.O.Q for the inventory management.

• This attempts to balance the income foregone on cash held by the firm against the transactions cost of converting cash into marketable securities and vice versa.

W.J.BAUMOL Model

Assumptions :• That a firm uses cash at an already known rate

per period & this will remain constant.

Two terms:1. Holding cost: there is always a cost of holding cash by the

firm. This cost may be known as opportunity cost (interest foregone) on the investment of this cash.

2. Transaction cost: whenever a cash is converted into marketable securities or vice versa. (commission, brokerage etc.)

W.J.BAUMOL Model

• An optimum cash balance is found by controlling the holding cost so as to minimize the total cost of holding cash.

• In other words, we can say, the cash is recovered by selling marketable securities in such a way that the transaction cost is optimally balanced with the holding cost of cash.

• This model is based on the proposition that in order to reduce the holding cost the firm should reduce / keep the least amount of cash in hand.

• However the cash level depletes , the firm can acquire cash by selling out some marketable securities.

• But every time, firm transacts in this way, it bears transaction cost (which a firm will try to do occasionally, as possible). And this could be done by maintaining a higher cash level involving a high holding cost.

• Thus a firm has to deal with the holding cost as well as transaction cost.

limitations

1. Constant rate of use of cash. (hypothetical assumptions), the cash outflows in any firm is not regular.

2. The transaction cost will be difficult to measure since it depends upon the type of investment and the maturity period.

MILLER ORR MODEL

• (In 1966) this is the extension of Baumol model which is not applicable if the demand of cash is not steady.

• It argues that changes in cash balance over a given period are random in size as well as in direction.

• Assumption:1. Out of two assets i.e. cash & marketable (through later

there is a expectation of yield)2. Transfer of cash to marketable securities & vice versa

is possible without delay. (but of course at some cost).

MILLER ORR MODEL H buy R• sell L

H: upper limit (beyond which cash level is not allowed to go)

L: not allowed to reduce.

MILLER ORR MODEL

• If cash level reaches H, part of cash should be invested in marketable securities in such a way that cash balance comes down to a predetermined level called RETURN LEVEL.

• If the cash balance reduces below L then sufficient marketable securities should be sold to realize so that the cash balance is restored at a return level R