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 assets, that is, receivables and inventory get eventually converted into cash. This underlines the significance of cash management.

MOTIVES FOR HOLDING CASH:
The term ‘cash’ with reference to cash management is used in two senses. In a narrow sense, it is used broadly to cover currency and generally accepted equivalents of cash, such as cheques, drafts and demand deposits in banks. The broad view of cash also includes near-cash assets, such as marketable securities and time deposits in banks. The main characteristics of these are that they can be readily sold and converted into cash. They serve as a reserve pool of liquidity that provides cash quickly when needed. They also provide a short term investment outlet for excess cash and are also useful for meeting planned outflow of funds. Here, the term cash management is employed in broader sense. Irrespective of the form in which it is held, a distinguishing feature of cash, as an asset, is that it has no earning power. There are four primary motives for maintaining cash balances – 1) Transaction motive 2) Precautionary motive 3) Speculative motive 4) Compensating motive

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dividends and so on. wages. But the inflows (receipts) and outflows (disbursements) do not perfectly coincide or synchronise. dividends and so on. payments exceed inflows. there is a regular inflow of cash to the firm from sales operations. For example. These receipts and payments constitute a continuous two-way flow of cash. a firm would not need cash for transaction purposes. taxes. Although a major part of transaction balances are held in cash. To ensure that the firm can meet its obligations when payments become due in a situation in which disbursements are in excess of the current receipts. This refers to the holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business. a part may also be in such marketable securities whose maturity conforms to the timing of the anticipated payments. Of the receipts of cash and its disbursements could exactly coincide in the normal course of operations. 2 . at other times. such as payment of taxes. At times. returns on outside investments and so on. it must have adequate cash balance.1) Transaction motive: An important reason for maintaining cash balances is the transaction motive. A firm enters into a variety of transactions to accomplish its objectives which have to be paid for in the form of cash. receipts exceed outflows while. The requirements of cash balances to meet routine cash needs is known as the transaction motive and such motive refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts. operating expenses. cash payments have to be made for purchases. Similarly. financial charges like interest.

The more unpredictable are the cash flows. Such cash balances are usually held in the form of marketable securities so that they earn a return.2) Precautionary motive: In addition to the non-synchronisation of anticipated cash inflows and outflows in the ordinary course of business. strikes 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 order for goods as the customer is not satisfied Sharp increase in cost of raw materials The cash balances held in reserve for such random and unforeseen fluctuations in cash flows are called as precautionary balances. a firm may have to pay cash for purposes which cannot be predicted or anticipated. Another factor which has a bearing on the level of such cash balances is the availability of short-term credit. 3 . the larger is the need for such balances. If a firm can borrow at short notice to pay for unforeseen obligations. In other words. Thus. it will need to maintain a relatively small balance and vice versa. precautionary cash balance serves to provide a cushion to meet unexpected contingencies. precautionary motive of holding cash implies the need to hold cash to meet unpredictable contingencies. The unexpected cash needs at short notice may be the result of: • • • • • Floods.

While for some of these services banks charge a commission or fee. Usually clients are required to maintain a minimum balance of cash at the bank. 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 purchase at favourable prices 4) Compensating motive: Yet another motive to hold cash balances is to compensate banks for providing certain services and loans. transfer of funds and so on. the banks themselves can 4 .3) Speculative motive: It refers to the desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business. for others they seek indirect compensation. such as clearance of cheque. supply of credit information. Since this balance cannot be utilized by the firms for transaction purposes. the speculative motive represents a positive and aggressive approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. While the precautionary motive is defensive in nature in that firms must make provisions to tide over unexpected contingencies. Banks provide a variety of services to business firms.

banks require a borrower to maintain a minimum balance in his account as a condition precedent to the grant of loan. The requirement of precautionary balances can be met out of short-term borrowings. the two most important are the transactions motive and the compensation motive. Business firms normally do not speculate and need not have speculative balances. This is presumably to ‘compensate’ the bank for a rise in the interest rate during the period when the loan will be pending. Compensating balances are also required by some loan agreements between a bank and its customers. Of the four motives of holding cash balances. 5 .use the amount to earn a return. During periods when the supply of credit is restricted and interest rates are rising. Such balances are compensating balances.

The advantages of adequate cash are: i) It prevents insolvency or bankruptcy arising out of the inability of a firm to meet its obligations ii) The relationship with the bank is not strained iii) It helps in fostering good relations with trade creditors and suppliers of raw materials. employees and so on. At the same time. Meeting Payments Schedule In the normal course of business. firms have to make payments of cash on a continuous and regular basis to suppliers of goods. to have sufficient cash to meet the cash disbursement needs of a firm. A basic objective of cash management is to meet the payment. there is a constant inflow of cash through collections from debtors. The importance of sufficient cash to meet the payment schedule can hardly be overemphasized. therefore. as prompt payment may help their own cash management iv) A cash discount can be availed of if payment is made within due date 6 . aptly described as a the ‘oil to lubricate the ever-turning wheels of business: without it the process grinds to a stop. Cash is. that is.OBJECTIVES OF CASH MANAGEMENT The basic objectives of cash management are two-fold :– a) To meet the cash disbursement needs (payment schedule) b) To minimize funds committed to cash balances These are conflicting and mutually contradictory and the task of cash management is to reconcile them.

as shown above. should be to have an optimal amount of cash balances. Keeping in view these conflicting aspects of cash management. There are two aspects involved in cash planning: first. two conflicting aspects have to be reconciled.v) It leads to a strong credit rating which enables the firm to purchase goods on favourable terms and to maintain its line of credit with banks and other sources of credit vi) To take advantage of favourable business opportunities that may be available periodically vii) The firm can meet unanticipated cash expenditure with a minimum of strain during emergencies. an examination of those factors which have a bearing on the firm’s required cash balances. fires or a new marketing campaign by competitors Keeping large cash balances. ensure prompt payment together with all the advantages. may mean failure to meet the payment schedule. a review of the approaches to achieve optimum cash balances. 7 . A low level of cash balances. The aim of cash management. Minimizing Funds Committed To Cash Balances The second objective of cash management is to minimize cash balances. The advantage of prompt payment of cash can well be realized by sufficient and not excessive cash. implies a high cost. therefore. But it also implies that large funds will remain idle. as cash is a non-earning asset and the firm will have to forego profits. A high level of cash balances will. second. we propose to discuss the planning/determination of the need for cash balances. such as strikes. In minimizing the cash balances. however. on the other hand.

For this purpose. Every shortage of cashwhether expected or unexpected. there may be some unexpected shortfall. the extent of non.involves a cost ‘depending upon the severity. Short Costs Another general factor to be considered in determining cash needs is the cost associated with a shortfall in the cash needs. the inflows and outflows have to be forecast over a period of time. duration and frequency of the shortfall and how the shortage is 8 .synchronization of cash receipts and disbursements. there would be no need for cash balances. The technique adopted is a cash budget. In addition. depending upon the planning horizon which is typically a one-year period with each of the 12 months being a sub period. A properly prepared budget will pinpoint the months/periods when the firm will have an excess or a shortage of cash. The first consideration in determining the cash need is. therefore. The cash forecast presented in the cash budget would reveal periods of cash shortages.FACTORS DETERMINING CASH NEEDS The factors that determine the required cash balances are: 1) Synchronization of cash flows 2) Short costs 3) Excess cash balance 4) Procurement and management and 5) Uncertainty Synchronization Of Cash Flows The need for maintaining cash balances arises from the non-synchronization of the inflows and outflows of cash: if the receipts and payments of cash perfectly coincide or balance each other.

refusal to sell. handling of securities. commitment charges and other expenses relating to the loan. a substantial loss because of a temporary shortage of cash. 4) Cost associated with deterioration of the credit rating which is reflected in higher bank charges on loans. Included in the short costs are the following: 1) Transaction costs associated with raising cash to tide over the shortage. 9 . Procurement and Management These are the costs associated with establishing and operating cash management staff and activities. 3) Loss of cash-discount. loss of image and the attendant decline in sales and profits. and so on. They are generally fixed and are mainly accounted for by salary. If large funds are idle. demands for cash payment. 2) Borrowing costs associated with borrowing to cover the shortage. stoppage of supplies. the implication is that the firm has missed opportunities to invest those funds and have thereby lost interest which it would otherwise have earned.covered. Excess Cash Balance Costs The cost of having excessively large cash balances is known as the excess cash balance cost. that is. These include items such as interest on loan.. This loss of interest is primarily the excess cost. This is usually the brokerage incurred in relation to the sale of some short-term near-cash assets such as marketable securities. Expenses incurred as a result of shortfall are called short costs. storage. 5) Penalty rates by banks to meet a shortfall in compensating balances.

dividends. however. defaults and unexpected cash needs. 10 . The first requirement is a precautionary cushion to cope with irregularities in cash flows. be mitigated through 1) Improved forecasting of tax payments. capital expenditure.Uncertainty and Cash Management The impact of uncertainty on cash management is also relevant as cash flows cannot be predicted with complete accuracy. unexpected delays in collection and disbursements. The impact of uncertainty on cash management can. and 2) Increased ability to borrow through overdraft facility. and so on.

Relevance At present many companies make an effort to reduce the costs incurred by owning cash. One the important analytical model for cash management is the Baumol Model. the next aspect relates to the determination of cash needs. Baumol Model The Baumol model of cash management is one of many by which cash is managed by companies. Use of Baumol Model The Baumol model enables companies to find out their desirable level of cash balance under certainty. The Baumol model of cash management is useful in this regard. namely (a) minimizing cost cash models and (b) cash budget Cash management/conversion models While it is true that financial managers need not necessarily follow cash management models exactly but a familiarity with them provides an insight into the normative framework as to how cash management should be conducted. 11 .DETERMINING CASH NEED After the examination of the pertinent considerations and cost that determine cash needs. They also strive to spend less money on changing marketable securities to cash. It is extensively used and highly useful for the purpose of cash management. There are two approaches to derive an optimal cash balance.

all such deals have variable costs and fixed costs. The company is capable of predicting its cash necessities. Assuming ABC Ltd can sell its marketable securities in 12 . The company should be making its cash payments at a consistent rate over a certain period of time. the rate of cash outflow should be regular. The annual yield on these marketable securities is 20%. They should be getting this money at regular intervals. In other words. Under normal circumstances. They should be able to do this with a level of certainty.Assumptions There are certain assumptions or ideas that are critical with respect to the Baumol model of cash management: • The particular company should be able to change the securities that they own into cash. It should stay the same for a considerable length of time. The conversion of these securities into cash entails a fixed cost of cash per order. • • • Equational Representations in Baumol Model of Cash Management: • • • Holding Cost = k(C/2) Total Cost = k(C/2) + c(T/C) Transaction Cost = c(T/C) Illustration The ABC Ltd requires Rs. The company should also get a fixed amount of money. keeping the cost of transaction the same. The company is aware of the opportunity cost required for holding cash. 30 lakhs in cash to meet its transaction needs during the next three month cash planning period. It holds marketable securities of an equal amount.

i = interest rate earned per planning period on investment in marketable securities.50. prepare a table indicating the economic lot size using numerical analysis. Solution: Formula to calculate optimal conversion amount: C = 2bT i Where C=optimal conversion amount/amount of marketable securities converted in to cash per order.000. T= projected cash requirement during the planning period.00.00.000.50.000. 13 . Rs 7. Rs 15.000. Rs 3. Rs 6.000. b= cost of conversion into cash per lot/transaction.00.any of the five lot size: Rs 1.

(iii) it enables a firm which has sufficient cash to take advantage of cash discounts on its accounts payable . The firm has. the net cash position (surplus or deficiency) of a firm as it moves from one budgeting subperiod to another is highlighted by the cash budget.CASH BUDGET Cash budget : Management Tool A firm is well advised to hold adequate cash balances but should avoid excessive balances. the finance manager can select the best alternative. (iv) it helps to arrange needed funds on the most favourable terms and prevents the accumulation of excess funds. finally. In other words. The cash budget is probably the most important toll in cash management. to formulate dividend policy. In contrast. to assess its need for cash properly. represents a higher risk. to pay obligations when due . the is no organizational deficiency. the management would be forced to accept the best terms offered in a difficult situation. (ii) it pinpoints the period when there is likely to be excess cash. With pressing needs and little time to explore alternative avenues of financing. therefore. 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 . It is a statement showing the estimated cash inflows and cash outflows over the planning horizon. 14 . These terms will not be as favourable. may suddenly find itself short of funds. It is a device to help a firm to plan and control the use of cash. It identifies the periods when there might be a shortage of cash or an abnormally large cash requirement. a firm which does not budget its cash requirements. The various purpose of cash budgets are: (i) to coordinate the timings of cash needs. since the lack of planning indicates to the lender. With adequate time to study his needs. The firm. therefore.

For instance. These may be described as the elements of the cash budgeting system. The subdivision will 15 . even a daily budget may be called for. The planning horizon means the time span and the sub periods within that time span over which the cash flows are to be projected.Elements/Preparation of Cash Budget Thus. a year and divide it into quarterly intervals. The idea behind subdividing the budgeting period into smaller intervals is to highlight the movement of cash from one sub period to another. is to ascertain whether at any point of time there is likely to be an excess or shortage of cash. may be appropriate. on a weekly or even a daily basis. If the flows are subject to extreme fluctuations. There is no fixed rule. as a tool to predict cash flows over a given period of time. such a firm may prepare a cash budget covering a long period. it is likely that the estimates will just beyond the period cannot be accounted for and the work associated with the preparation of the budget becomes excessive. may be necessary. In the case of a firm whose flows are uncertain. The coverage of a cash budget will differ from firm to firm depending upon its nature and the degree of accuracy with which the estimates can be made. if the flows are expected to be stable and dependable. a quarterly budget. the period selected should be neither too long too short. The first element of a cash budget is the selection of the period of time to be covered by the budget. The planning horizon of a cash budget should be determined in the light of the circumstances and requirements of a particular case. divided into monthly intervals. It is referred to as the planning horizon. monthly budgets. the principal aim of the cash budget. sub – divided. Where flows are affected by seasonal variations. As a general rule . say. The preparation of a cash budget involves various steps. If it is too long.

These two–fold classifications of cash budget items are based on their nature. The factors that generate cash flows are generally divided. While the former category includes cash flows generated by the operations of the firms and are known as operating cash flows. non-cash items such as depreciation and amortization are excluded. The items included in the cash budget are only cash items. into two broad categories. the latter consists of financial cash flows. The second element of the cash budget is the selection of the factors that have a bearing on cash flows. 16 . (a) operating. for purposes of the construction of cash budget.provide information on the fluctuation in the cash reservoir level during the time span covered by the budget. and (b) financial.

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