structure · • stress the importance of cash forecasting and techniques of ... to increase...
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Management of InventoryUNIT 6 MANAGEMENT OF CASH
Objectives
The objectives of this unit are to:
• Highlight the role of cash in the operation of business.
• Explain different motives behind holding the cash.
• Discuss various determinants that affect and create uncertainty in the cash flows.
• Stress the importance of cash forecasting and techniques of forecasting.
• Discuss the importance of managing cash surplus and cash-in-transit.
• Explain the need for good management information system in cash management.
Structure6.1 Introduction
6.2 Motives of holding cash
6.3 Determinants of Cash Flows
6.4 Cash Forecasting
6.5 Managing Uncertainty In Cash Flow Forecast
6.6 Managing Surplus Cash
6.7 Managing Cash-in-transit
6.8 MIS in Cash Management
6.9 Summary
6.10 Key Words
6.11 Self Assessment Questions
6.12 Further Readings
6.1 INTRODUCTION
Cash is basic input to start a business unit. Cash in initially invested in fixedassets like plant and machinery, which enable the firm to produce products andgenerate cash by selling them. Cash is also required and invested in workingcapital. Investments in working capital are required because firms have to storecertain quantity of raw materials and finished goods and provide credit terms tothe customers. The cash invested in raw materials at the beginning of workingcapital cycle goes through several stages (work-in-progress, finished goods andsundry debtors) and gets released at the end of cycle to the fund freshinvestment needs of raw materials. The firm needs additional cash during its lifewhenever it needs to buy more fixed assets, increase the level of operations andany change in working capital cycle such as extending credit period to thecustomers. In other words, the demand for cash is affected by several factorsand some of them are within the control of the managers and others are outsidethe control of the managers. Cash management thus, in a broader sense ismanaging the entire business.
In the context of working capital management, cash management refers tooptimising the benefits and costs associated with holding cash. As describedearlier, unless the cash is put into use, there is no benefit derived out just byholding it. Further, holding cash without a purpose also costs firm either directlyin the form of interest or opportunity income that could be earned out of thecash. At the same time, it is not possible to operate the business without holdingcash. Many of us take cash while going to office though we have bought thetickets earlier and taking lunch with us or have a credit facility to take lunch.
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Management of CurrentAssetsThough no major demand for cash is expected, we feel uncertain without cash.Firms also feel uncertain without holding cash for various reasons. For instance,any delay in collection will force the firm to delay the salary to employees orpayment to creditors or bankers which in turn affects long-term relationship withthem. Firms, which are experiencing volatile price behaviour in some of thecritical raw materials, would like to have more cash to buy the material,whenever the price is low. There are several other motives of holding cash andwe will shortly discuss these motives in detail.
The objective of cash management is to balance the cost associated with holdingcash and benefits derived out of holding the cash. The objective is best achievedby speeding up the working capital cycle, particularly the collection process andinvesting surplus cash in short-term assets in most profitable avenues. The term‘cash’ under cash management thus refers to both cash and credit balance in thebank and short-term investments in marketable securities. Table 6.1 shows totalamount invested in cash and marketable securities of few industries. The figuresin the Table shows that investment in cash and marketable securities is huge andhas gone up several times in reflection to growth of operations. Investments incash and marketable securities also show significant differences betweenindustries even after taking into account the differences in the number of firms indifferent industries.
Table 6.1: Investments in Cash and Marketable Securities of Manufacturing Industries(Rupees in Crores)
Industry 1999 2000 2001 2002 2003
Food & Beverages 2306.34 2424.03 2372.82 2585.53 3014.78
Textile 2460.09 1884.74 2489.38 2506.74 2625.73
Chemicals 12287.85 13337.33 13618.50 17504.49 18334.49
Non-metallic Minerals Products 1289.58 1135.09 1369.33 1349.02 1449.67
Metals & Products 5143.03 5188.58 6362.79 6050.11 7325.18
Machinery 8926.23 9986.02 11714.53 15334.53 18197.25
Transport Equipment 5998.40 5419.28 5744.91 5871.66 7933.06
Diversified 9852.56 9242.45 7208.94 7467.43 6849.64
Miscellaneous 721.01 1040.25 948.77 953.74 1617.11
Total 48985.09 49657.77 51829.97 59623.25 67346.91
Note: Figures in brackets indicate the number of companies of the industry usedto compile industry aggregates.
Thus, while structuring cash management policy, the firm has to consider theinternal business process and external environment. The important issues relatingto management of cash are:
• Understanding the motives behind holding the cash;
• Quantifying the cash needs of the firms to achieve the above motives; and
• Developing a cash management model to enable operating managers to takedecisions on investing surplus cash and selling investment to fund shortage.
Activity 6.1
1) How do you relate cash management in a broader sense? What is its focus inthe context of working capital management?
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Management of Inventory2) Why do we need to manage cash?
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3) Collect the cash and marketable securities data of your company or any onecompany you are familiar with from published accounts for the last three orfive years. Examine the trend and its relationship with level of operation.
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6.2 MOTIVES OF HOLDING CASH
Fixed assets are used to convert the raw materials into finished goods.Investments in current assets cannot be avoided due to constraints in technology,manufacturing process and customers behaviour of demanding different models ata point close to her/his house and at the point of consumption. Inventory and billsreceivables have become essential to continue business operations more fruitfully.Emphasis is always given to reduce the investments in these assets and thusreduce the working capital cycle. Investment in cash and marketable securitiesare the least productive assets. Often, firm is not dependent on this asset in themanufacturing process nor is required for creating inventory or selling. Thus, thebasic question is why firms hold cash and marketable securities? Some of thereasons for holding cash are listed below.
Transaction Motive: Money is required to settle customers’ bills, pay salary andwages to workers, pay duties and taxes, etc. Some cash balance is to bemaintained to complete these transactions. The amount to be maintained for thetransaction motive depends on the cash inflows and outflows. Often, firmsprepare a cash budget by incorporating the estimates of inflows and outflows toknow whether the cash balance would be adequate to meet the transactions.
Precautionary or Hedging Motive: The transaction motive takes into accountthe routine cash needs of the firm. It is also based on the assumption thatinflows are as per estimation. However, the future cash needs for transactionpurposes are uncertain. The uncertainty arises on account of sudden increase inexpenditure or delay in cash collection or inability to source the materials andother supplies on credit basis. The firm has to protect itself from suchcontingencies by holding additional cash. This is called as precautionary motive ofholding cash balance. Precautionary cash balance is also maintained to meet thenon-routine needs. Generally, cash required for precautionary motive is held in theform of short-term securities with the objective to earn atleast some positivereturn. The securities are sold and cash is realised as and when suchemergency demand for cash arises.
Speculative Motive: If the firm intends to exploit the opportunities that mayarise in the future suddenly, it has to keep some cash balance. The term“speculative motive” to some extent is a misnomer since cash is not kept toconduct any speculation but merely to exploit opportunity. This is particularlyrelevant in commodity sector, where the prices of material fluctuate widely indifferent periods and the firm's business success depends on its the ability to
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Management of CurrentAssetssource the material at the right time. Some of the materials, whose prices showsignificant volatility, are cotton, aluminium, steel, chemicals, etc. Surplus cash isalso used for taking over of other firms. Firms that intend to take advantage onthe above counts keep large cash balances with them, though the same are notrequired either for transactions or as a precaution.
Managing uneven supply and demand for cash: Firms generally experiencesome seasonality in sales, which leads to excess cash flows in certain period ofthe year. This is not permanent surplus and cash is required at different pointsof time. One possible solution to address this mismatch of cash flows is to payoff bank loans whenever there is excess cash and negotiate fresh loan to meetthe subsequent demands. Since firms are exposed to some amount ofuncertainty in getting the loan proposal sanctioned in time, the surplus cash isretained and invested in short-term securities.
In a competitive environment, firms also felt the desire of holding cash to getflexibility in meeting competition. For instance, when a competitor suddenlyresort to massive advertisement and other product promotion, it forces other firmsto increase advertisement cost or some other sales promotion such as “free gift”for every purchase or lottery scheme, etc. Amount held in the form of cash andmarketable securities of twenty manufacturing companies of BSE-30 Index(Sensex) firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in2003 (Table 6.2).
Table 6.2 :Investments in Cash & Marketable Securities of Manufacturing Companies inSensex
(Rupees in Crores)
Company 1999 2000 2001 2002 2003
Oil & Natural Gas Corpn. 2393.83 3878.12 50326.59 25706.20 2488.52
Bajaj Auto 1150.11 2223.90 5525.18 4183.43 2331.03
Bharat Heavy Electricals 537.43 1807.72 9722.93 8276.70 2020.30
Hindustan Petroleum Corpn. 672.22 4770.76 15203.81 9784.78 1743.80
Hindalco Industries 928.75 1461.26 7660.84 2658.63 1475.62
Grasim Industries 446.21 1326.67 6247.97 2991.17 1217.34
Tata Power Co. 660.62 1491.27 8431.65 3457.94 1088.82
Larsen & Toubro 291.52 7675.29 15561.74 10016.02 1075.50
Hindustan Lever 1030.38 2378.12 6767.00 3873.85 917.38
HDFC 1623.57 3341.00 20213.30 2622.43 883.78
Wipro 37.12 191.03 2585.45 1673.09 848.84
Tata Motors 877.38 2191.60 9299.45 3068.67 750.64
Mahanagar Telephone Nigam 1356.42 265.08 16888.20 7994.18 698.41
Reliance Industries 6425.93 8055.17 36959.51 6825.49 648.33
Tata Iron & Steel Co. 735.70 1763.74 12889.90 3576.49 628.80
Reliance Energy 519.87 1479.14 4612.13 2114.79 465.55
Gujarat Ambuja Cements 272.15 383.50 2988.98 618.90 209.07
Cipla 94.55 407.18 1047.85 637.02 145.88
Zee Telefilms 18.10 3505.76 4570.49 796.41 145.42
Associated Cement Cos. 80.06 466.20 3476.45 901.24 114.13
I T C 445.73 1946.49 6376.15 2538.60 105.80
Ranbaxy Laboratories 50.41 647.86 2389.91 1327.16 44.70
Dr. Reddy’S Laboratories 44.01 211.10 1066.85 550.40 22.92
Hero Honda Motors 83.56 337.31 1163.95 674.47 13.58
Satyam Computer Services 38.28 56.48 1146.54 674.65 10.75
Bharti Tele-Ventures 13.85 324.96 1865.38 600.89 0.00
Total 20827.76 52586.71 254988.20 108143.60 20094.91
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Management of InventoryActivity 6.2
1) Can we consider investments in cash and marketable securities as leastproductive?
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2) Why companies maintain huge cash and marketable securities despite theybeing least productive assets? List down a few industries, where the demandfor cash for speculative motive would be more.
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3) Analyse the data given in Table 6.2. Why do you feel that in somecompanies the cash balance has gone up over the years whereas in a fewcases, it remains same or has gone down?
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6.3 DETERMINANTS OF CASH FLOWS
Investments in cash and marketable securities depend on the cash flow of thefirm. Firms, which primarily sell the product against cash (e.g. petroleumproducts, gold, etc.) may not require much cash balance to be maintained sincethere is always cash inflows to the firm. Banks and insurance companies, whichreceive cash on regular intervals, can work with smaller cash balance at branchlevel. On the other hand, firms in a competitive industry which have to extendcredit to the customers need to maintain large amount of cash to meet differentmotives of holding cash. Cash flows are also affected by several other factors,which can be broadly classified into internal and external factors.
Internal Factors
Internal factors relate to policies of management relating to working capitalcomponents and future growth plan. These factors are determined by the firmand arising out of management decisions. The internal factors that affect thecash flows of firms are discussed below.
Production-related policies: Production-related policies determine production plan,which in turn affect, purchase of material and other components and level offinished goods. For example, firms that follow production policy of manufacturingfor inventory and then selling the product in the market will normally carry highvolume of material and other inventory in order to ensure smooth productionprocess. The increase in purchase activity will demand more cash compared toother firms, which follow order-based production policy. Similarly, if productionprocess is automated, then the demand for cash to pay wages to workers will
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Management of CurrentAssetscome down significantly. Firms following JIT, MRP, FMS, etc., could reduce thegeneral level of inventory and they also favourably contribute to the demand forcash.
Policies on Discretionary Expenses: Expenses not directly connected to themanufacturing process, which have some amount of flexibility in timing theexpenditure are called discretionary expenses. Examples of discretionary expensesare Research & Development cost, advertisement, replacement of a machinebefore its life, etc. Some of the discretionary expenditure is planned in advancewhereas in other cases, the need arises suddenly. The management policy onsanctioning discretionary expenses has a bearing on the cash flow. Ifmanagement follows a flexible policy and allows the expenses after seeing thecurrent cash position, the pressure on cash will come down significantly.
Policies on Receivables: The policies on trade receivable, which is last stage ofoperating cycle, affect the cash flow. The credit period and cash discounttogether determine the flow of cash. While liberal credit policy delays cash flow,attractive discount policy speeds up the collection process.
Financial Policies: Firms, which pursue active capital expenditure programme inthe form of new projects or expansion, need cash. While part of resources israised externally in the form of fresh debt or equity, the balance is expected fromthe internal surplus. The financing policy of the firm determines the cash flow.Internal funding is also expected to meet any delay in raising external sources.These firms may require more cash to meet such eventuality. Similarly, thedividend policy of the firm affects the cash flow. Firms, which follow liberaldividend policy, will put pressure on internal cash flows.
Payment Polices: The ability to get credit terms for purchases of materials andother products and services also affects the cash flow. If the firm maintainscreditworthiness, it could always find it easy to source material and other itemson credit basis. On the other hand, if materials and other items are to be boughton cash basis or only limited credit period is available, the demand for cashincreases.
External Factors
External factors can be broadly classified into monetary and fiscal factors andindustry-related factors. These are discussed below.
Monetary and Fiscal Factors: The central bank (Reserve Bank of India)periodically spells out monetary policies and through which influences theavailability of money. The monetary policy in turn is affected by the fiscal factorsof the country. In a liberal monetary policy regime, it will not be difficult to getcredit from banks as well as from suppliers of material and services. Thus, theneed for holding cash is thus limited to transaction motive. Cash required forprecautionary and speculative motives can be easily raised. Unit-2 on 'OperatingEnvironment of Workimg Capital' contains more discussion on monetary policyissues.
Industry-related factors: Industry-related factors affect the cash flow in theform of practices followed by other firms in the industry on terms of sale andnature of material and services required. Cash flow will be positive in retailindustry. Cash flow will be cyclical for industries such as plantation and agro-based products. Cash flow is volatile in certain industries like entertainment andhospitality industry. Cash flow is generally negative for manufacturing industries.Depending on the nature of cash flow relating to the industry, the demand forholding cash is determined.
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Management of InventoryActivity 6.3
1) Why do we need to analyse the cash flows to determine the balance to bemaintained in the form of cash and marketable securities?
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2) List down the factors that affect the cash flows of the firm.
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3) Name any three industries in which you expect a positive or negative cash flow.
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6.4 CASH FORECASTING
The discussion in the previous section shows various factors that affect the cashinflows and outflows. An understanding of determinants of cash inflows andoutflows alone is not adequate in managing cash. It is necessary to forecastcash flows using our understanding on the determinants of cash flows of thefirm. Cash forecasting is the core of cash management. A firm, which is notforecasting the cash flows as a part of managing the cash flows, will faceunanticipated cash shortage. In order to mitigate the unanticipated cash shortage,typically the firm will either delay the payment process or resort to emergencyborrowing. Delay in payments to suppliers will affect the price or delay insupply, causing increased cost or expensive production delays. Emergencyborrowing will also increase the cost of borrowings. A firm with surplus cashflow will also find it difficult to manage the cash without a forecast. Since theinformation on how long the surplus cash will remain is not known, there is noway for the firm to effectively use the cash. If short-term surplus cash isinvested for long-term, it will create unanticipated cash shortage. Surplus cashlying within the firm will also encourage operating managers to pile up theinventory and resort to many unproductive investments. Thus, cash forecast isinevitable in managing the cash.
A major problem in forecasting of cash flows is that it cannot be doneindependently. The determinants are many as seen in the previous section andalso highly inter-related with other budgets. Cash forecast/budget integratesseveral other forecasts.
Types of Cash Forecast: The cash forecasts generated by the firms can bebroadly differentiated under two dimensions: the length of periods included withinthe cash forecast and the approaches to cash flows used in the cash forecast.Cash forecasts are normally prepared for one-year period but the forecast isbroken down to several smaller periods like, quarterly, monthly or weekly cashforecasts. The choice of particular periodicity depends on the volume of cash
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Management of CurrentAssetsflows, nature of cash flows and the desirability of the management. Firms broadlyfollow two approaches in the preparation of cash forecast. Under the directapproach, firms forecast various receipts and payments items for different periodsand consolidate the forecasts into cash budget. Under indirect approach, firmsstart with forecast of earnings and then add back all non-cash expenses anddeduct all non-cash revenues, to get cash forecast. This is similar to preparationof funds flow/cash flow statement, which is normally prepared using historicalaccounting information as a part of financial statement analysis.
The format of monthly cash budget is illustrated in Table 6.3. It lists out majorcash inflow and outflow that arise in the normal operation of business. Theexample also shows how the cash deficit and cash surplus are dealt with tomaintain the minimum balance.
Table 6.3 : Monthly Cash Budget
Cash Flow Item January February March Total forthe Quarter
Beginning cash balance 60000 66078 61320 60000Collection from sales/receivables 415488 373392 368280 1157160Total 475488 439470 429600 1217160DisbursementsSuppliers 68648 60960 56957 186565Payment of Salaries & Wages 49202.4 42150 44670 136022.4Other Overhead Expenses 30160 28290 29130 87580S&A Expenses 51400 48850 50130 150380Total 199410 180250 180887 560547Excess / -Inadequacy 276078 259220 248713 656613Minimum Balance 60000 60000 60000 60000Cash Available / -Needed (A) 216078 199220 188713 596613Financing
Borrowing/ -Repayments 0 0 0 0Fresh Equity Issue 0 0 0 0Sell/ -Acquire Investments -210000 30000 60000 -120000Payment to Fixed Assets -230000 -230000Receive/ -pay interest 2100 1800 3900Dividend -250000 -250000Total of Financing Plan (B) -210000 -197900 -188200 -596100Closing Cash Balance (A - B) 66078 61320 60513 60513
Methods of Cash Flow Forecasting: The above Table gives the output as aresult of forecasting exercise. However, each item in the above Table requiresseveral computations and assumptions. While a few cash flow items areindependent, several others are dependent on many other variables. Forecastingmethod depends on the nature of cash flows. Some of the common methods offorecasting are explained below:
1. Independent Cash Flow Items: These cash flow items are independent ofother factors or predetermined. Lease rent for office building, property tax,insurance premium, etc., are few items which are determined independently.
2. Dependent Cash Flow Items: Many cash flow items are dependent onother financial variables. For instance, cash collection from sundry debtorsdepends on sales of the previous months, credit terms and collection pattern.An understanding of the relationship between the cash flow variables isimportant in forecasting the cash flows. If only one variable is associatedwith cash flow items, then estimation is not difficult. On the other hand, ifseveral variables are associated with a cash flow item, econometric modelsare used to get the value. For instance, if customers take more than two
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Management of Inventorymonths credit period to pay the amount, it is possible to construct a multipleregression model to measure the proportion of amount collected from variousmonths’ sales. The model uses cash collection of the month as dependentvariable and previous months sales values as independent variables.
3. Growth in Cash Flow Items: As business grows, the cash flow items alsosee a positive growth. Suppose the total sales grow at five percent everyquarter and credit (60 days) sales is eighty percent of the sales. If fortypercent of the customers pay at the end of two months in time, another 40percent pays at the end of three months and the balance 20 percent pays atthe end of fourth month the amount collected from the customers is alsoexpected to show an uptrend due to growth in sales.
The most usual approach to cash forecasting is the Receipts and Payments methodsas accepted in Table-6.3. After the firm has determined what types of receipts andpayments are important in its overall cash flow, an important question is how toforecast the future level of inflows and outflows. There are four common techniquesof forecasting these items of receipt and payment.
a) Direct Method – In using this technique, it is assumed that the variable to beforecast is independent of all other variables, or alternatively, is predetermined.The variables (e.g.lease rental) is forecast by using its expected orpredetermined level.
b) Proportion of Another Account – This technique is used to project financialvariables that are expected to vary directly with the level of another variable. Forexample, if sales volume increases, it is natural that more units will have to beproduced to replenish inventory. It is then reasonable to project certain directcosts of production, such as direct materials, as a per cent of sales.
c) Compounded Growth – This method is used when a particular financialvariable is expected to grow at a steady growth rate over time. The formula usedis:
Yt = (1 + g) Y t-1
Where Yt-1 is the prior period’s level of y and g is the growth rate.
d) Multiple Dependencies : Under this technique the variable is considered to beinfluenced by more than one factor. The statistical technique of linearregression is often employed with historical data to determine whichexplanatory variables are significant in explaining the dependent variable.We will see the application of regression technique after a while.
Since cash forecasts deal mostly with the near future, many of the items on the cashforecast are usually estimated by some variation of the spot method. The bases ofthese spot estimates are usually the firm’s other financial plans. Remaining estimatesare mostly on a proportion of another account’ basis, the another account often beinga particular period’s sales. The other two methods are employed less frequently.
It is a common experience that forecast of disbursements is much easier thanreceipts, because the cash manager can rely on internal information and knowledgeof payment policy in order to determine what needs to be paid and when. Besides, hehas the knowledge of firm’s other plans (or budgets) and can make use of theforecasting techniques described above. However, a major challenge for him comesin estimating the receipts from the collection of the firm’s receivables. In thisregard, an useful forecasting method is to analyse the historical payment patterns todetermine the proportion of credit sales that are collected at various times after thedate of sale, and then to use this information (along with the estimates of future sales)to project future receipts. This has been illustrated in the unit 14 of MS-4 (under the
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Management of CurrentAssetshead ‘Sales Work Sheet’). We may, however, adopt a better and a more sophisticatedapproach. In this all collection rates are estimated simultaneously by regressing pastsales figures against past collections. The estimated coefficients of the sales figuresin the regression can be interpreted as the collection proportions, and the standarderrors of the estimated regression coefficients as the uncertainty inherent in theestimation of these collection proportions.
Let us take an example. Suppose that a firm has regressed its monthly collections forpast months against the appropriate past monthly sales figures and has obtained thefollowing results:
Ct = 0.754 St – 1 + 0.241St – 2
(0.250) (0.087)
The figures in parentheses below the estimated collection rates are the standarderrors of these collection rates. In this equation, Ct is the collection from receivable inperiod t, St – 1 is the sales in period t –1 (say, previous month), and St – 2 is the sales inperiod t-2 (say, two months previously). Assume also that these were the onlystatistically significant explanatory variables (the variables like St – 3, St – 4, etc. anddummy variables to assess seasonality, were not significant), and that the overallestimated equation was highly significant. We may now interpret the regressionresults in the following way. The estimated collection rates are 75.4 per cent(regression coefficient on St – 1) of the previous month’s sales and 24.1 per cent(regression coefficient on St – 2) of the sales from two months previously. The impliedbad debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. Thestandard error figures are used to test the statistical significance of the estimatedregression coefficients.
Simulation Approach
Simulation analysis permits the financial manager to incorporate in his forecastingboth most likely value of ending cash balances (surplus/deficits) for each of theforecast periods (say, for each month over the next quarter) and the margin of errorassoicated with this estimate. It involves the following steps: First, probabilitydistributions for each of the major uncertain variables are developed. The variableswould generally include sales, selling price, proportion of cash and credit sales,collection rates, production costs, and capital expenditures. Some of these variableshave the greatest influence upon cash balances. Clearly, more time and effort shouldbe spent in obtaining probability distributions of these variables. Second, values aredrawn at random for the variables from their respective probability distributions, andusing these values each balances are estimated. Third, the process is repeatedseveral times (say, 100 times). Needless to say, such tedious and cumbersomecomputations are done on computer. From the trial results, information of the kind asshown in table 6.4 would be generated.
Table 6.4 : Hypothetical Simulation Results
Month Average Cash Balance Standard Deviation(Rs. in '000) (Rs. in '000)
April 3,104 334
May 1,258 375
June -1,221 353
July -1,104 402
August -363 403
September 591 421
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Management of InventoryHow can the finance manager use the results of the simulation? The usefulness ofthe results as shown in Table 6.4 lies in the fact that summary statistics (i.e. averagecash balances and standard deviation) can be used to determine upper/lowerestimates of cash surplus or deflcit for each month, with a probability of say 95per cent that cash balance will remain within the estimated range. Assuming that thedistribution of month-ending cash balances is normal, we can obtain the upper/lowerestimates by applying the following formula.
Upper/Lower Estimates
= Average Cash Balance + Z × Standard Deviation
where Z is the standard normal variate.
With the information of this type in hand, finance manager can now address theformulation of appropriate investement and financing strategies. Let us now proceedwith some examples to illustrate the point.
Consider our hypothetical simulation results and assume that the costs of havinginsufficient cash and the costs of hedges (i.e. financial arrangement to fall back uponin case of shortage of cash) are such that the firm desires to incur, at maximum, a 5per cent chance of having insufficient cash to cover expenses. What is the maximumamount for which the firm should secure a line of credit? The maximum expecteddeficit is in the month of June, with a mean of Rs. 12,21,000 and a standard deviationof Rs. 3,53,000. The Z statistic for 95 per cent confidence interval is 1.645; and 1.645times of Rs. 3,53,000 is Rs.5,80,685. The maximum amount that the firm shouldarrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5per cent chance that the actual borrowing needs in June will be greater than this anda 95 per cent chance that the requirements will be less than this.
Let us now consider that the firm is contemplating how much of the estimated surplusin September to invest in a 60-day investment. How much can the firm invest andhave only 10 per cent chance of having to resell the investment in September? Zstatistic for 90 per cent confidence interval is 1.28; times of Rs. 4,21,000 isRs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent chancethat cash surplus in September will be less than Rs. 52,120. So, the firm can investthe amount in the 60-days investment and have a 10 per cent chance that they willhave to liquidate the investment prior to maturity.
The above exmaples are intended to illustrate the mechanics of manipulating means,standard deviations, and probabilites of cash balances rather than to present realistichedging strategies. In practice, the array of possible hedging strategies is quite a bitmore complicated. One is required to consider various alternatives and the assoicatedcosts and risk in hedging strategies.
Activity 6.4
1) Why do we need to forecast cash flows while managing the cash?
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Management of CurrentAssets2) Collect cash flow statement given in the annual report of a large listed
company for the last five years. Comment on the trend in the component.
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3) How does simulation approach help in cash forecasting?
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6.5 MANAGING UNCERTAINTY IN CASH FLOWFORECAST
Cash flow forecast is crucial in cash management. Thus, the efficiency of cashmanagement is directly related to the ability to accurately forecast cash flows.Unfortunately, two important cash flow variables namely sales and collectioncarry a lot of uncertainty and thus affects the cash flow forecast. It is alsodifficult to adjust the production and purchasing activity immediately in reaction tothe lower sales and there is always some time lag between decline in sales andactual adjustment in manufacturing activities. Sales and collection pattern areaffected by several variables and most of them are external factors such ascompetition from internal and external market, seasonality, changes in consumers’taste, recession in the market, government policy, etc. Firms have little control onthese variables. Recognising and managing cash flow variation is thus anotherimportant issue in cash management. There are several methods through whichfirms recognise and manage the uncertainty associated with cash flow variation.
Sensitivity Analysis: The impact of changes in cash flow variables on cashbalance is examined through sensitivity analysis. The objective of the analysis isto determine the most sensitive cash flow variables that will place the cashmanagement in a difficult position. This information is useful to evaluate thepossibility of cash flow variable affected to that extent, plan to ensure that thecash flow variable is within the normal limit and prepare a contingency plan.
Scenario Analysis: Here cash flows are forecasted under different assumptionsand cash requirement under different scenarios is worked out. Depending on thelevel of risk taking capability, firm selects a scenario and uses it for cashmanagement
Simulation Analysis: It is an extension of scenario analysis. In scenario analysis,the user defines possible scenarios and the computer generates the cash forecast.In simulation, the computer is allowed to generate various scenarios based onrandom numbers. Since a large number of scenarios are generated, it is possible
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Management of Inventoryto define the distribution of cash flow forecast and uncertainty associated withthe forecast.This is discussed in more detail in the previous section.
Holding a Stock of Extra Cash or Near-Cash Asset: This is the simplestsolution to manage the uncertainty associated with the forecasting of cash flow.This is relied upon when the level of uncertainty is high.
Extra Borrowing Capacity: If the uncertainty analysis model helps to figure outthe period in which the firm is likely to face serious problem of cashmanagement, then it is worth to negotiate with bankers or other financingagencies well in advance for additional temporary credit. It is possible to have astandby arrangement with the bank or financial intermediaries.
Using Interest-Rate Derivatives: If uncertainty in cash flows is on account ofexpected changes in the interest rate affecting the interest income or interestpayments, the interest-rate derivatives such as interest rates futures and interestrate options are useful to manage this part of risk.
Activity 6.5
1) Why the actual cash flows show significant variation from the forecast?
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2) How do you recognise and measure the uncertainty associated with cash flows?
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3) List down important techniques in managing the uncertain cash flows?
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6.6 MANAGING SURPLUS CASH
Profit making firms have to generate surplus cash at the end of operating cyclesince the cash collected from debtors is greater than cash invested initially.However, in reality, many profit making firms see the pressure of negative flowof cash. There are several reasons for this situation. The mismatch of inflowsand outflows and diversion of short-term funds for long-term needs are twomajor reasons for this condition. Though it is not desirable to divert the short-term funds for long-term needs, often firms resort to this diversion if there is
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Management of CurrentAssetssome delay in getting long-term funds. The situation is set right once the firmreceives the long-term funds. In other words, profit-making firms periodicallygenerate cash surplus even though they face pressure on cash flows in othertimes. The issue is how to deal with such surplus cash. Excess cash balance isthe least productive asset of the firm and thus should be minimised.
Firms normally resort to investing short-term surplus cash in short-term liquidsecurities to earn some return. The firm has to decide on two issues at thisjuncture. First, it should decide on investment avenues and products. The amountto be invested is the next important decision.
The investment product is typically short-term, highly liquid government securities.The Indian money market is not fully developed and generally restricted to banksand other institutional investors. The investment widely used by the Indiancorporate sector to place short-term capital in Unit-64 scheme of Unit Trust ofIndia. Earlier, investment in Unit-64 enjoyed certain tax benefit also for thecorporate sector. Since many private sector mutual funds have floated open-ended debt-based schemes, the demand for this source of investment hasincreased in recent times. Certificate of deposits, commercial paper and inter-corporate deposits are other popular schemes in which short-term funds areplaced. After liberalisation of the economy, money and capital markets havebecome active and the volume and variety in the instruments traded hasincreased. The advent of money market mutual funds has broaden the scope forsurplus cash investment.
The amount to be invested depends on transaction cost associated withinvestment and period for which the amount is available for investment. Sincethe return on short-term securities is generally low, frequent investment anddivestment increases the transaction cost and thus affect the overall return.Investment optimisation models like Baumol, Miller-Orr and Stone are available toguide firms to decide on how much to be invested. These models will bediscussed in detail in the next unit.
6.7 MANAGING CASH-IN-TRANSIT
The discussion covered so far generally relates to forecasting of future cashflows and managing the surplus or deficit cash flows. A related issue of cashmanagement is improving collection efficiency, particularly speeding up theconversion of cash-in-transit to cash. The concept is explained with simpleexample. Suppose a firm in New Delhi sold Rs.10 lakhs worth of goods toanother firm located in town near Madurai. At the end of credit period, when theselling firm made an enquiry over phone about the payment, the customerinformed that they have posted the cheque on that day and gave the paymentdetails. The postal department will take about four to five days to deliver thepost to the seller firm. The seller firm may take about a day or two to processthe receipt and the cheque will be deposited on sixth or seventh day in the bankaccount. Since it is outstation cheque, the bank will take about another one totwo weeks to collect the money since the collection bank again has to send thecheque by post to issuer’s bank and get the collection details by post. In otherwords, it will take about two to three weeks to complete the whole exercise. Thebuyer in this process enjoyed another two-three week credit, which is called''Float'. On a Rs. 10 lakhs, the interest cost for three weeks is around Rs.10000 (1%). The electronic clearing system that reduces the collection time atthe bank end is not available at all places. The issue is how the selling firmspeeds up the collection process. Though a simple solution is to request thecustomer to pay through demand draft and send the draft by speed-post orcourier after deducting the cost of DD and courier charges, customers may not
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Management of Inventoryagree to the proposal since they loose the float Thus, we need to look into ourcollection system for improvement.
Selection of Banks with Accelerated Clearing Facilities: An analysis of thetime delay in the collection process, particularly collection of outstation cheques,shows that a significant part of delay is at banks end. If a firm is havingcustomers through out the country, then it is necessary to select a bank, whichgives accelerated clearing facilities. Banks may be atleast insisted to process theclearing through speed post to cut down the delay arising on account of postaltransaction.
Maintaining Accounts in Several Branches: To cut down the time delay inclearing outstation cheques, the firm can open accounts in important cities, wherethe number of clients are more and deposit the cheque in the branches to getlocal clearing facility. Funds collected may be electronically transferred to thehead office.
Acceleration of Cheque Processing at the Firm: This is within the control ofthe firm. Often, the sales person, who collects the cheque from the customer willfirst show the collection to his/her boss before sending the cheque to accountsdepartment. If the boss is not available or in a meeting, the cheque will be in histable for a day or two before it moves to accounts department. The person,who receives the cheque in the accounts department, will first identify therelevant bill. If there is any shortfall in the value, this will be discussed with thesales department. After reconciling the cheque amount with the bill, the accountsdepartment prepares receipt and makes an entry in the cash-book. The chequenow moves to the person who is preparing challan for depositing into the bank.If the cheque is deposited beyond certain hours, this will not be taken up for theday’s clearing and the cheque has to wait for one more day for collection. Allthese activities can be done after noting down the relevant cheque details anddirectly handing over the cheque to the employee who is looking after the banktransaction. It requires simplification of procedure involved in processing ofcollection.
Use of Lockboxes: The lockbox is a post office box number to which some orall the customers would be requested to mail their cheques. The lockbox will beopened in several cities and the local branches of the bank are authorised toopen the box and clear the cheques. The amount collected under lockbox istransferred to the notified account. This concept is popular in the US and otherdeveloped countries but not prevalent in India.
Electronic Funds Transfer and Anywhere banking: The advent of bankingtechnology and the spread of internet facilities has changed the face of corporatecash management. The more towards paperless economy reduces many of thedifficulties in dealing with cheques/drafts. It should be clear from the priordiscussion that the time necessary for transmittal of cash from one firm toanother revolves largely around the passing from one hand to another of a pieceof paper, ie., the cheque. if we can eliminate this paper there will be a majorsaving in the time and cost.
The system of electronic remittances introduced by many foreign and Indianbanks has almost achieved the objective of cheque-less payment mechanisum.Added to this, the concept of 'Anywhere Banking' practised by many banks alsois helping speedy flow of remittances. with these developments, it should not bedifficult for the firms to eliminats the 'Float. unfortunately, many corporates inIndia are not much in favour of the' Electronic Funds Transfer System' mainlybecause of their habit of delaying the the payments. It may however, be hoped,
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Management of CurrentAssetsthat the collection process in the near future will be fully automatic, as far as thebanking operations are concerned.
Activity 6.6
1) Why is it important to manage the cash-in-transit?
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2) What are different options available before the firm in improving collectionefficiency of cash-in-transit?
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3) Draw an activity chart that speeds up the process of depositing the cheque inthe bank account from the time of receipt?
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4) Outline the impact of internet banking on corporate cash menagement.
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6.8 MIS IN CASH MANAGEMENT
The preparation of cash budget based on forecast of cash flows is only thestarting point of cash management. It is the planning part of cash management.The forecast of cash flows and budget exercises help the management to locatecash deficient and surplus periods. Managers decide on dealing with the deficitand surplus, which is decision-making part of cash management. The exercise iscompleted, if the control element is also brought into the cash managementsystem. The control element is required since the operations of the businessenterprise may often deviate from the plan. It is very common that widedeviation arises between planned and actual cash flows, which keeps the financialmanagers always under severe pressure. Often, attention of the managers isdrawn after the problem developed to a full level. Thus, the crucial issue in cashmanagement is continuous information on actual cash flows and reporting ofdeviation. Minor deviation can be tackled by postponing certain discretionarypayments or speedy collection of book debts by offering cash discounts. If thedeviation is expanding, it requires major corrections in the form of negotiatingfresh loan with bankers and improving the collection mechanism. Such corrective
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Management of Inventoryactions are possible by developing a good reporting system that highlights suchdeviations without loss of time.
The daily cash report is the best vehicle for obtaining a running comparisonbetween the forecast and actual cash flows. Daily cash reporting is useful evenif cash budget and forecast are not available on daily basis. It helps themanagers to understand the flow of cash on daily basis and a comparison ofcumulative figures with the budget indicates the target still to be achieved to keepthe budget in force. In addition, the reporting on daily basis to top managementforces the operating people to work efficiently. This is very useful sinceaccounting profit cannot be computed on daily basis and available only at the endof quarter.
Meaningful analysis can be done by consolidating cash flows on daily basis intotwo documents namely Cash Flow Budget-Actual Variance Analysis andCumulative Cash Flow Statement for the year to date. The formats for the tworeporting documents are given below.
Table 6.5 : Cash Flow Budget-Actual Variance Analysis from …….. to ……….
Cash Flow Item Budget Actual Variance Remarks
Beginning cash balance
Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S&A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Cash Available / -Needed (A)
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan (B)
Closing Cash Balance (A - B)
Table 6.6 : Cumulative Cash Flow Statement For the Year-to -Date
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Management of CurrentAssetsCash Flow Item Budget for Performance Target for
the Year till Date the RemainingPeriod
Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S&A Expenses
Total
Excess / -Inadequacy
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan
A variety of cash reports designed for specific needs of individual companies arein vogue for checking cash flows and ensuring constant availability of adequatecash. For example, if the firm has only a few large customers, the topmanagement would like to have customer-wise cash collection reporting to speedup the process of collection at the highest level. The information collected fromthese statements is useful to fix responsible centres for variance and initiatecorrective steps, which are essential steps in control exercise. The correctivesteps include short-term efforts such as speeding up the collections by chasing afew large customers and long-term policy changes such as revising credit periodor credit-granting decision.
6.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is theleast productive asset of the firm and thus managers take every effort tominimise the cash holding. Despite the least productive nature of the asset, firmshold large cash. There are several motives behind holding cash. Cash is requiredto settle dues of the firm. Since cash inflows are uncertain and outflows arecertain, firms keep additional cash. Cash kept for these two purposes are calledtransaction motive and precautionary motive. Cash is also kept to overcome themismatch of inflows and outflows, cyclical behaviour of cash flow pattern andexploit short-term opportunities, like rising prices and aquisition of control.
Cash flows are affected by internal factors such as operating and financialpolicies and external factors such as monetary and fiscal policies and practices ofindustry. An understanding on factors that affect the cash flows is useful toforecast future cash flows, which is core aspect of cash management. There areseveral methods of forecasting cash flows and often different methods areemployed to forecast individual cash flow items. Cash forecasting is converted
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Management of Inventoryinto cash budgets and cash budget is broken into quarterly, monthly and weeklycash budgets. Budgets are prepared to understand whether cash inflows andoutflows match with each other and if not, to know the period in which themismatch arises. Managers plan to deal with such mismatches by initiating actionin advance.
Despite careful planning, actual cash flows often deviate from the budgets due toinherent uncertainty associated with cash flow variables. There are several toolssuch as sensitivity analysis, simulation, etc., available to evaluate the impact ofuncertainty on cash flows. The uncertainty associated with the cash flows ismanaged by holding additional cash, negotiating stand-by borrowing facility andinterest rate derivatives. Management of cash includes dealing with surplus cashand cash-in-transit. While surplus cash is to be invested in short-term securitiesafter conducting cost-benefit analysis, cash-in-transit are managed by takingefforts to reduce the float and float amount.
While planning and decision-making are essential for any management system, thesystem completes only when appropriate control mechanism is built into thesystem. Management information system assumes importance in this context incash management system. Periodical reporting on cash flows and varianceanalysis of such flows is essential to effectively manage the cash flows. Theobjective of the entire exercise is to ensure availability of cash to conduct smoothbusiness and at the same time to minimise the investments in this least productiveasset.
6.10 KEY WORDS
Transaction Notice : cash balances required to meet the expenses towards day today operations of a business.
Precautionary Motive: Cash balances required to take care of the contingenciesthat arise due to unplanned activity.
Speculative Motive: Cash balances kept by a business unit to take advantage ofincreasing prices of raw materials, services, etc.
Discretionary Expenses: Expenses that are not directly related to the manufacturingprocess, but have some amount of flexibility in timing the expenditure.
Cash Forecast: An estimate of cash inflows and outflows for a specified period.
Simulation Analysis: A method of making forecasts by generating a large numberof probable estimates (generally with the help of a computer) of cash inflows andoutflows and compare the position for their effect on ending balance in a referenceperiod.
Sensitivity Analysis: A method of studying the impact of changes in cash flowvariables on cash balance.
Float: Refers to cash in transit, which can be utilised by the paying form till it isactually withdrawn
Electronic Funds Transfer: A mechanism by which receipts payments are handledthrough electronic machines.
Cash Budget: A forecast of cash inflows and outflows for a period.
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Management of CurrentAssets6.11 SELF-ASSESSMENT QUESTIONS
1. Explain the objective of cash management system. How do you deal withthe conflicting nature of the objectives?
2. What are the principal motives of holding cash in a business despite itsunproductive nature?
3. Discuss internal and external determinants that affect the flow of cash.
4. Why is it important to forecast the cash flows in managing the cash?
5. How do you measure the uncertainty associated with cash flows? Discussthe products available to manage the uncertainty of cash flows?
6. What is flotation? How do you cut down the flotation time?
7. Discuss the importance of cash flow reporting in the management of cash?
8. Digital Electronics Ltd. is preparing cash budget for the next quarter in orderto negotiate with the bankers for additional credit. The sales departmentinforms that March sales was Rs. 220 lakhs and the expected sales for thenext four months are Rs. 120 lakhs, Rs. 160 lakhs, Rs. 220 lakhs and Rs.160 lakhs respectively. The company sells 30% of sales through cash andthe balance on credit basis with one month as credit period. The bad debtslevel is negligible. Cash outflows consist of payment to creditors, salary andwages, other operating expenses, purchase of fixed assets and taxes. Thematerial and labour costs constitute 30% and 45% respectively of the sales.While raw materials are purchased in one-month credit, wages are paid inthe same month. Other operating expenses cost Rs.50 lakhs and are paid inthe same month. Other non-operating cash flow items are Rs. 150 lakhs inMay (fixed assets), Rs. 120 lakhs in June (fixed assets), Rs. 160 lakhs inJune (corporate tax) Rs. 140 lakhs in April (interest and instalment of loan)and Rs. 100 lakhs in May (dividend). The cash at the beginning of thequarter was Rs. 150 lakhs and the company’s cash policy is to hold 5% oftotal cash expenses of the next month as minimum closing balance of thecurrent month. Prepare a monthly cash flow statement for the quarter andhighlight the surplus/deficit for each month.
9. Kidcat is a leading manufacturer of toys and sports items for kids. Theindustry is facing severe competition from unorganised sector, which imitatethe Kidcat products immediately. The sales of the firm during the last twoyears show significant volatility. The firm decides to use simulation this timewhile preparing cash budget. The firm has sold Rs. 100 lakhs worth of toysduring the month of March and expects the following possible ranges of salesbetween April to June of the next year.
Sales (Rs. in lakhs) 40 80 120 160
Probability 20% 30% 30% 20%
The customers generally pay within a month of sales. The material costassociated with the product works out to 40%, which are paid after a monthand fixed cost including labour cost of the firm per month is Rs. 30 lakhs.Fixed costs are paid in the same month. Conduct a simulation exercise of100 trails using random numbers and find the cash balance at the end ofeach month and their distribution. (Hint: Use of Spreadsheet is recommendedto conduct simulation exercise).
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Management of Inventory10. The internal analysis of cash flows of a large textile manufacturing companyshows a wide variation in cash balances during the next year. The minimumcash balance expected during the second quarter of the year was -Rs. 340lakhs (negative balance indicating shortage of cash) and the maximum valueof Rs. 120 lakhs during the month of February. The above figures areestimates and likely to see significant volatility. The firm presently enjoys overdraft limit of Rs. 300 lakhs and contemplating to increase the limit to Rs. 400lakhs to meet the additional cash need and also uncertainty associated withcash flows. The bank is willing to provide the additional loan at 14% interestrate but insists the firm to accept a commitment charge of 0.25% per monthon the additional borrowing limit. The commitment charge has to be paid onunused part of the overdraft facility. For instance, if a firm draws Rs. 340lakhs in August, it has to pay interest at the rate of 14% on Rs. 340 lakhsand 0.25% on Rs. 60 lakhs. If the firm decides not to accept the offer, itwill be exposed to cash out position and emergency borrowing would cost2% interest per month. The firm expects a maximum emergency borrowingof Rs. 200 lakhs at different points of time during the year. Advice the firmon accepting the additional loan with a commitment charge of 0.25%.
6.12 FURTHER READINGS
Brealey, Richard A and Myers, Stewart C., Principles of Corporate Finance,Tata-McGraw Hill, New Delhi
Frederick C. Scherr, Modern Working Capital Management: Text and Cases,Prentice Hall, Englewood Cliffs, NJ.
Joshi, R.N. Cash Management: Perspectives, Principles &Practice, New AgeInternational (P) Ltd. New Delhi.
Keith V. Smith, Guide to Working Capital Management, McGraw-Hill BookCompany, New York
Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi
Prasanna Chandra, Financial Management, Tata-McGraw Hill, New Delhi
Ramamoorthy, V.E. Working Capital Management, Institute for FinancialManagement and Research, Madras.
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