CASH MANAGEMENT

Nature of Cash

Cash is the

medium of exchange

for

purchase of goods and services and for discharging liabilities. In cash management the term cash has used in two senses.
 

Narrow sense Broad sense

Narrow Sense: Under this, cash covers currency and generally accepted equivalents of cash, viz., cheques , demand drafts .

Broad Sense: Here, cash includes not only the above stated but also near cash assets. easily sold and converted into cash. They are marketable securities. The marketable security can

Why does a firm need cash ?
There are three primary reasons for a firm to hold cash:  To meet the needs of daily transactions  To protect the firm against uncertainties of its cash flows  To take advantage of unexpected investment opportunities

Motive /Objective of holding cash Transaction motive  Precautionary motive  Speculative motive  .

rent etc. such as materials. tax. wages. .Transaction motive • Transaction motive for holding cash or near-cash balances is driven by the need to make planned payments for items.

 For ex-floods.Precautionary motive It is driven by the need to protect the firm against being unable to satisfy unexpected demands for cash.  .slow down in collection of debtors. strikes . increase in cost of raw materials etc.

 Ex: Purchase of material at reduced price.Speculative motive It refers to the desire of a firm to take advantage of oppertunities. dealing in commodities in bulk purchasing and selling when rates are considered favourable.  .

Surplus cash balance cost 4.Management cost .Cost of transaction .Determinants of cash need 1.Short costs. .Cost of borrowing -Cost of loss of cash discount -Cost of penalty rates 3.Synchronisation of cash flows 2.

 Cash reports for control.  Investment of surplus funds .  Long term Cash forecasting.cash planning and control  Management of cash  Cash budgeting.

Managing cash flow  Accelerating cash collection Slowing down cash payment  .

Accelerating cash collection Prompt payment of customers Early conversion of payment into cash (Float) Decentralization of collection or concentration banking .

Slowing down cash payment Payment on last date Centralization of payment .

.Postal float-Time taken by the post office in transferring the cheques from the customer to the firm.Lethargy-Time taken in processing the cheques within the company and sending them to bank for deposit.Float There is a time lag between the time a cheque is prepared by customer and the time the funds are credited to firms account. 2. 1.

These three collectively known as deposit float.Time taken by the bank in collecting the payment from the customers bank.3.Bank float. .

Cash Management Techniques Speeding Collections Speeding up collections Slowing down payments Concentration Banking Concentration banking is a collection procedure in which payments are made to are collected at these centers regionally dispersed collection centers. deposited in local Cheques several times a day and banks for quick clearing. .

Cash Management Techniques Speeding Collections Lockboxes • A lockbox system is a collection procedure in which payers send their payments to a nearby post office box that is cleared by the firm’s bank several times a day. .

.Cash Management Techniques Speeding Collections Other Techniques ⇒ • Wire transfers is a telecommunications book keeping device that removes funds from the payer’s bank and deposits them into the payees bank thereby reducing collections float. • Automated clearing house (ACH) are preauthorized electronic withdrawals from the payer’s account that are transferred to the payee’s account via a settlement among banks by the automated clearinghouse.

Cash Planning Cash planning is a technique to plan and control the use of cash. .  Cash forecasts are needed to prepare cash budgets.  Cash Forecasting and Budgeting   Cash budget is the most significant device to plan for and control cash receipts and payments.

.Short-term Cash Forecasts or cash budget  The  important functions of shortterm cash forecasts To determine operating cash requirements  To anticipate short-term financing  To manage investment of surplus cash.

It is a sound tool of managing daily cash operations. .The Receipt and Disbursements Method It gives a complete picture of all the items of expected cash flows.

however. or unanticipated demands may cause large disbursements. For example. suffers from the following limitations: Its reliability is reduced because of the uncertainty of cash forecasts. collections may be delayed. . This method.

Long-term Cash Forecasting  The major uses of the long-term cash forecasts are: 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. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully. It helps to improve corporate planning.

the important ones are: (i) the daily cash report. and ii) the monthly cash report.REPORTS FOR CONTROL  Cash reports provide a comparison of actual developments with forecast figures. Among the several types of cash reports. . ii) the daily treasury report. They are helpful in control and revision of cash forecasts on a continual basis.

. The monthly cash report. receipts.it provides complete pictures of cash.it shows the opening balance. debentures and creditors.   The daily cash report.It shows the actual receipts and payments in monthly basis. marketable securities. The daily treasury report. payments and the closing balance in daily basis.

public sector bonds. before they are required for capital expenditures.  .  These funds may be deployed in a variety of ways.INVESTMENMT OF SURPLUS FUNDS Companies often have surplus funds for short period of time. like money market instruments. or some other purpose. loan repayment. Short term deposit etc.

.Cash Conversion Models Cash conversion models are used to help in determining the optimal into quantity securities cash of to when marketable convert needed (and vice versa).

Optimum Cash Balance Optimum Cash Balance under Certainty: Baumol’s Model  Optimum Cash Balance under Uncertainty: The Miller–Orr Model  .

   The cash conversion quantity depends on a number of factors. and the firm’s demand for cash. . the rate of interest. The objective of these models is to balance the costs and benefits of holding cash or investing in marketable securities. like the fixed cost of transferring funds between cash and marketable securities.

.Baumol Model • The Baumol model is a simple approach that provides for cost-efficient cash balances by determining the optimal cash conversion quantity.

 The firm manages its cash by calculating two costs: Conversion cost: the cost of converting marketable securities into cash and vice versa. and Opportunity cost: the cost of holding cash rather than marketable securities .

The opportunities cost of holding cash is known and it remains stable over time. . The cash payment of the firm occur uniformly over a period of time and is known with certainty.Assumption of Baumol Model     The firm knows its cash needs with certainty. The transaction cost is known and remain stable.

Total cost of holding cash Opportunity Costs The investment income foregone when holding cash.Costs of Holding Cash Costs of holding cash Trading costs increase when the firm must sell securities to meet cash needs. Trading costs C* Size of cash balance .

F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed R = The opportunity cost of holding cash C=Economic conversion lot C C – 2 1 2 3 Time If we start with C. spend at a constant rate each period and replace our cash with C when we run out of cash. 2 The opportunity cost C C of holding – is – ×R 2 2 . our average cash balance C will be – .

The Baumol Model As we transfer C each period we incur a trading cost of F each period. If we need T in total over the planning T period we will pay F – C times. T The trading cost is – × F Time C C C – 2 1 2 3 .

The Baumol Model C T Total cost = × R + × F 2 C C Opportunity Costs × R 2 T Trading costs × F C C* 2T C = ×F R * Size of cash balance The optimal cash balance is found where the opportunity costs equals the trading costs .

The Baumol Model The optimal cash balance is found where the opportunity costs equals the trading costs. For finding the Economic Conversion Lot Opportunity Costs = Trading Costs C T ×R = ×F 2 C Multiply both sides by C T ×F 2 C2 C = 2× ×R =T ×F R 2 2TF * C = R .

000 cash demand during the coming year. .500.1.30 to convert marketable securities into cash and vice versa. anticipates Rs.The management of Ram Co. The firm has determined that it costs Rs. Find the Economic Conversion Lot. a small distributor of sporting goods. The marketable securities portfolio currently earns an 8% rate of return.

08=Rs33541.Solution  C=√(2x1500000x30)/0.02 .

L. investments are sold to raise cash to get us up to the target cash balance. $ When the cash balance reaches the upper control limit U. cash is invested elsewhere to get us to the target cash balance Z.The Miller-Orr Model  The firm allows its cash balance to move randomly between upper and lower control limits. Z L Time . U When the cash balance reaches the lower control limit.

Determine the interest rate (R). To use the Miller-Orr model. . the manager must do four things: 1. 3. 4. Set the lower control limit for the cash balance. Estimate the trading costs of buying and selling securities (F).(L) Estimate the standard deviation of daily cash flows. 2.

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