Cash management

Introduction
• Cash management is one of the key areas of working
capital management.
• Apart from the fact that it is the most liquid current asset,
cash is the common denominator to which all current
assets can be reduced because the other major liquid
asset, that is, receivables and inventory get eventually
converted into cash.
• This underlines the significance of cash management.
• Cash is the ready currency to which all liquid assets can
be reduced.
• Near cash implies marketable securities viewed the way
as cash because of their high liquidity.
 Motives for holding cash
• Transaction motive
• Precautionary motives
• Speculative motives
• Compensating motives
 Transaction motive
• An important reason for maintaining cash balances is the
transaction motive.
• This refers to holding of cash to meet routine cash
requirements to finance the transaction which a firm
carries on in the ordinary course of business.
• For example, cash payment have to be made for
purchases, wages, operating expenses, financial
charges like interest, taxes, dividends and so on.
• If the receipt of cash and its disbursements could exactly
coincide in the normal course of operations, a firm would
not need cash for transaction purposes.
 Precautionary motives
• In addition to the non-synchronization of anticipated cash
inflows and outflows in the ordinary course of business,
a firm may have to pay cash for purpose which cannot
be predicted or anticipated.
• The unexpected cash need at short notice may be the
result of:
• Floods, strike and failure of important customers;
• Bills may be presented for settlement earlier than
expected.
• Unexpected slow down in collection of accounts
receivable
• Cancellation of some orders for good as the customer is
not satisfied
• And sharp increase in cost of raw materials
 Cont’d
• The cash balance held in reserve for such random and
unforeseen fluctuations in cash flow are called
precautionary balances.
• Thus precautionary cash balance serves to provide a
cushion to meet unexpected contingencies.
• Such cash balance are usually held in the form of
marketable securities so that they earn a return.
 Speculative motives
• It refers to the desire of a firm to take advantage of
opportunities which presents themselves at unexpected
moments and which are typically outside the normal
course of business.
• The speculative motive represents a positive and
aggressive approach
• Firms aim to exploit profitable opportunities and keep
cash in reserve to do so.
 Cont’d
• The speculative motive helps to take advantage of :
• An opportunity to purchase raw materials at a reduced
price on payment of immediate cash
• A chance to speculate on interest rate movements by
buying securities when interest rates are expected to
decline.
• Delay purchases of raw materials on the anticipation of
decline in prices
• Make purchases at favorable prices
 Compensating motives
Yet another motive to hold cash balances is to compensate
banks for providing certain services and loans.
Banks provide a variety of services to business firms, such as
clearance of cheque, supply of credit information, transfer of
funds, and so on.
While for some of these services bank charges a commission
or fees, for other they seek indirect compensation.
Usually clients are required to maintain a minimum balance of
cash at the bank.
Since this balance cannot be utilized by the firms for
transaction purposes, the banks themselves can use the
amount to earn a return. Such balances are compensating
balances
 Cont’d
• The compensating cash balances can take either
of two forms
• (i) an absolute minimum, say, Rs 5 lakhs below
which the actual bank balance will never fall
• (ii) a minimum average balance, say, Rs 5 lakh
over the month

• Of the four primary motives of holding cash

balances the two most important are the
transaction motives and compensation motives.
 Objectives of cash
management
• Meeting payment schedules
• Minimizing funds committed to cash
balance.
 Factors determining cash
needs
Synchronization of cash flows
Short costs
(i) transaction costs
(ii) borrowing costs
(iii) loss of cash-discount
(iv) cost associated with deterioration of the credit
rating
(v) penalty rates
Excess cash balance cost
Procurement and management
Uncertainty and cash management
 Baumol model
• The Baumol model of cash management provides a
formal approach for determining a firm’s optimum cash
balance under certainty.
• It considers cash management similar to an inventory
management problem.
• The purpose of this model is to determine the minimum
cost amount of cash that a financial manager can obtain
by converting securities to cash, considering the cost of
conversion and counter-balancing cost of keeping idle
cash balances which otherwise could have been
invested in marketable securities
 Cont’d
• The total cost associated with cash management, according to
this model has two elements:
• (i) cost of converting marketable securities into cash and
• (ii) the lost opportunity cost.
• The baumol’s model makes the following assumptions:
• The firm is able to forecast its cash needs with certainty.
• The firms 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 same transaction cost whenever it converts
securities to cash.
 Cont’d
• Let us assume that the firm sells securities and starts
with a cash balance of C rupees. As the firm spends
cash, its cash balance decreases steadily and reaches
to zero. The firm replenishes its cash balance to C
rupees 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 below
 Cont’d
Cash balance

C/2 Average

0 T1 T3 Time
T2
 Cont’d
• The firm incurs a holding cost for keeping the cash
balance. It is an opportunity cost; that is the return
foregone on the marketable securities. If the
opportunity cost is i, then the firms holding cost for
maintaining an average cash balance is as follows:
• Holding cost or opportunity cost = i(C/2)
• Where i= interest rate that could have been earned
• C/2= the average cash balance that is, the
beginning cash (C) plus the ending cash balance
of the period (zero) divided by 2
 Cont’d
• The firm incurs a transaction cost whenever it converts
its marketable securities to cash. Total number of
transactions during the year will be total funds
requirements, T, divided by the cash balance, C, i.e. T/C.
the per transaction cost is assumed to be constant. If per
transaction cost is b then total transaction cost will be:
• transaction cost or total conversion cost per period =
b(T/C)
• Where b= cost per conversion
• T= total transaction cash needs for the period
• C= value of marketable securities sold at each
transaction
 Cont’d
• The total annual cost of demand for cash will
comprise of total conversion cost plus
opportunity cost symbolically it can be
expressed as
• i (C/2) +(b)(T/C)
 Cont’d
• To minimize the cost, therefore, the model
attempts to determine the conversion amount
that is the cash withdrawal which costs the least.
The optimum cash balance is obtained when the
total cost is minimum
• C= 2bt
i
 Cont’d
Annual
cost Total Cost
Slope = 0

iC
Minimum Opportunity Cost =
total cost 2

Tb
Transaction Cost =
C
Cash Balance
 Miller-Orr model
• The limitation of boumol model is that it dose not allow
the cash flow to fluctuate. Firm in practice do not use
their cash balance uniformly nor they are able to
predict daily cash inflows and outflows.
• The miller Orr model overcomes this shortcomings and
allows for daily cash flow variation .
• Miller Orr assumes that the changes in cash balance
over a given period are random in size
• The miller Orr model provides for two control limits the
upper control limit and lower control limit as well as
return point
 The Miller - Orr Model

Upper Limit Buy Securities

UL
Cash balance

Z or
Return point

LL
Lower Limit Sell Securities

Time
 Cont’d
• If the firms cash flows fluctuate randomly
and hit the upper limit, then it buys
sufficient marketable securities to come
back to the normal level of cash(the return
point ) similarly when the firms cash flow
wander and hit the lower limit it sells
sufficient marketable securities to bring the
cash level back to the normal level.
 Cont’d
• While the value of lower control limit (LL) is set by
the management based on what it considers to be
the minimum below which the cash balance should
not fall, the values of RP and UL have been derived
by miller Orr with the view to minimizing the total
ordering and holding costs.
• The following are the results of the analysis
• RP =3 3b(s.d)2 + LL
• 4I
• UL = 3RP-2LL
 Control of cash collection and
disbursement.
• The strategic aspect of efficient cash management
approach are:
• speedy collection of accounts receivables and
• delaying the payments on accounts payable.
• Speedy cash collections: in managing cash efficiently,
the cash inflow process can be accelerated through
systematic planning and refined techniques. There are
two broad approaches to do this. In the first place the
customer should be encouraged to pay as quickly as
possible. Secondly, the payment from customer should
be converted into cash without any delay.
 Prompt payment by
customer
• One way to ensure prompt payment by
customer is prompt billing. What the customer
has to pay and the period of payment should be
notified accuretly and in advance. The use of
mechanical devices for billing along with the
enclosure of a self-addressed return envelope
will speed up payment by customers.
• Another, and more important, technique to
encourage prompt payment by customers, is the
practice of cash discounts.
 Early conversion of payments
into cash.
• Once the customer makes the payment by writing a cheque in
the favor of the firm, the collection can be expedited by
prompt encashment of the cheque. There is a lag between the
time a cheque is prepared and mailed by the customer and the
time the funds are included in the cash reservoir of the firm.
Within the time interval three steps are involved:
• A) Transit or mailing time, that is, the time taken by the post
offices to transfer the cheque from the customer to the firm
referred to as postal float.
• B) Time taken in processing the cheque within the firm before
they are deposited in the banks, termed as lethargy;
• C) collection time within the bank, this is called bank float.
 Cont’d
• The early conversion of payment into cash, as a
technique to speed up collection of accounts
receivable, is done to reduce the time lag
between the posting of the cheque by the
customer and the realization of money by the
firm. The postal float lethargy and the bank float
are collectively referred to as deposit float. The
term float is defined as the sum of cheque
written by customer that are not yet useable by
the firm.
 Cont’d
• An important cash management technique
is reduction in deposit float.
• This is possible if the firm adopts he policy
of decentralised collections
• The principal method of establishing
decentralized collection network are
• Concentration banking
• Lock-box system
 Concentration banking
• Concentration banking is a system of operating through
a number of collection centers, instead of a single
collection center centralized at the firm’s head office.
• The basic objective of decentralized collection is to
minimize the lag between the mailing time from
customer to the firm under this system the firm will have
a large number of bank accounts operated in the areas
where the firm has its branches.
• All branches may not have the collection centers.
• The selection of the collection center will depend upon
the volume of billing.
 Cont’d
• The collection centers will be required to collect
cheques from customers and deposit it in their local
bank accounts.
• The collection center will transfer funds above some
predetermined minimum to a central or concentration
bank account. A concentration bank is one where the
firm has a major account usually disbursement account.
• Funds can be transferred to a central or concentration
bank by telex or fax or electronic mail.
• Decentralized collection system saves mailing and
processing time and thus reduces the deposit float.  
 Lock-box system
• Lock-box system another technique of speeding up the
mailing, processing time and, collection time is lock-box
system.
• In concentration banking cheques are received by a
collection center and after processing are deposited in the
bank.
• Lock-box system helps the firm to eliminate the time
between the receipts of cheques and their deposit in the
bank.
• In a lock-box system, the firm establishes a number of
collection centers, considering customer location and
volume of remittance.
 Cont’d
• At each center, the firm hires a post office box and
instructs its customers to mail their remittance in
the box.
• The firm’s local bank is given the authority to pick-
up the remittance directly from the lock box.
• The bank picks up the mails several times a day
and deposits the cheques in the firms account.
• For the internal accounting purpose of the firm the
bank prepares detailed records of the cheques
picked up.
 Cont’d
• Two main advantages are
1.The bank handles the remittance prior to deposit at a
lower cost.
2.The cheques are deposited immediately upon receipt
of remittance and their collection processes sooner
than if the firm would have processed them for
internal accounting purpose prior to their deposits.
•  Both the systems involve cost. Whether the system
should be used or no depends upon the comparison
between its cost and benefits.
 Delaying payments on
accounts receivable

• This can be done through:

• Avoidance of early payments
• Centralized disbursement
• Float
• Paying from a distant bank
• Accruals
 Strategies for managing
surplus cash
• Do nothing: the financial manager simply allows
surplus liquidity to accumulate in the current account.
This strategy enhances liquidity at the expense of
profits that could be earned from investing surplus fund.
• Make ad hoc investments: the financial manager
makes investments in some what ad hoc (unplanned,
unprepared) manner such a strategy makes some
contribution, though not the optimal contribution, to
profitability without impairing the liquidity of the firm. It is
followed by the firms which cannot devote enough time
and resources to management of securities.
 Cont’d
• Ride the yield curve: this is a strategy to increase the yield
from a portfolio of marketable securities by betting on interest
rate changes.
• If the financial manager expects that interest rates will fall in
the near future he would buy longer term securities as they
appreciate more, compared to short term securities.
• On the other hand, if the financial manager believes that the
interest rate will rise in the near future, he would sell longer
term securities.
• This strategy hinges (centered) on the assumption that the
financial manager has superior interest rate forecasting ability.
•  
 Cont’d
• Develop guidelines: a firm may develop a set of
guidelines which may reflect the view of the
management towards risk and return.
• Examples of such guidelines are:
• (i) Do not speculate on interest rate changes. (ii)
Hold marketable securities till they mature (iii) do
not put more than a certain percentage of liquid
funds in a particular security or instrument (iv)
minimize transaction cost
 
 Cont’d
• Utilize control limits: there are some models of
cash management which assumes that cash inflow
and outflow occur randomly (irregular) over time.
• Based on this premise, these models define the
upper and lower control limits.
• When the cash balance touches the upper limit, the
model prescribes that a certain amount should be
invested in the marketable securities and when the
cash balance hits the lower limit then a certain
amount of marketable securities should be liquidated.
 Cont’d
• Manage with a portfolio perspective: according to the
portfolio theory there are two key steps in portfolio
selection.
• Define the efficient frontier: the efficient frontier represents
a collection of all efficient portfolios. A portfolio is efficient if
and only if there is no alternative with (i) the same
expected return and a lower standard deviation, or (ii) the
same standard deviation and a higher expected return, or
(iii) a high expected return and a lower standard deviation
• Select the optimal portfolio: the optimal portfolio is that
point on the efficient frontier which enables the investor to
achieve the highest attainable level of utility.
 Stone model
• The Stone Model is somewhat similar to the Miller-Orr
Model in so far as it uses control limits.
• It incorporates, however, a look-ahead forecast of cash
flows when an upper or lower limit is hit to take into account
the possibility that the surplus or deficit of cash may
naturally correct itself.
• If the upper control limit is reached, but is to be followed by
cash outflow days that would bring the cash balance down
to an acceptable level, then nothing is done.
• If instead the surplus cash would substantially remain that
way, then cash is withdrawn to get the cash balance to a
predetermined return point.
 Cont’d
• Of course, if cash were in short supply and the lower control limit
was reached, the opposite would apply.
• In this way the Stone Model takes into consideration the cash
flow forecast.
• The goals of these models are
• To ensure adequate amounts of cash on hand for bill payments,
• To minimize transaction costs in acquiring cash when
deficiencies exist,
• And to dispose of cash when a surplus arises.
• These models assume some cash flow pattern as a given,
leaving the task of cash collection, concentration, and
disbursement to other methods.
 Long term cash
forecasting
• Long term cash forecast are prepared to give an idea of the
companies financial requirements in distant future. They are
not as detailed as short term forecast.
• Long term cash forecast can be made for a period of two
three or five years .
• Once a company has developed long term cash forecast it
can be used to evaluate the impact of say new product
developments or plant acquisitions on the firms financial
condition for a long period.
• Long term cash forecast reflects the impact of growth,
expansion or acquisition; it also indicates financing
problems arising from these developments.
 Cont’d
• The major uses of long term cash forecast are:
• It indicates as company’s future financial needs,
especially for its working capital requirements.
• It helps to evaluate proposed capital projects. It
pinpoints the cash required to finance these
projects as well as the cash to be generated by the
company to support them.
• It helps to improve corporate planning. Long term
cash forecasts compel each division to plan for
future and to formulate projects carefully.
 Short term cash forecast
• It is comparatively easy to make short term forecasts. The
important functions of carefully developed short-term cash
forecast are:
• To determine operating cash requirement
• To anticipate short term financing
• To manage investment of surplus cash
• Some more uses of these forecasts are:
• Planning reduction of short and long term debts.
• Planning forward purchase of inventories
• Taking advantages of cash discounts
• Guiding credit policies
 Cont’d
• Two most commonly used methods of
short term cash forecasting are
• The receipt and disbursement method
• The adjusted net income method
 Cash budget
• Cash budget is a statement of the inflows and outflows of
cash that is used to estimate its short term requirements.
• The cash budget is probably the most important tool in
cash management it is a device to help a firm to plan and
control the use of cash.
• It is a statement showing the estimated cash inflows and
outflows over the planning horizon.
• In other words the net cash position (surplus/ deficiency)
of a firm as it moves from one budgeting sub period to
another is highlighted by the cash budget.