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Published by: Chandan Kumar Tripathy on May 11, 2012
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Introduction Motives for Holding Cash Cash Flow Process and its Relevance Principles of Cash Management Collection and Disbursement Management
Collection Float and its Impact on Profitability

Cash Forecasting Cash vs. Marketable Securities
Baumol Model Miller-Orr Model

Chapter 24 Cash Management


Chapter 24 Cash Management 3 . The higher the cash in hand and bank balance. as it affects the profitability–liquidity position of the firm. But the funds tied up in cash in hand and in current accounts of banks give a yield of zero. the stronger is the liquidity position.INTRODUCTION Cash is the most liquid but least productive current asset. The determination of optimal cash balance assumes importance.

The two seemingly contradictory objectives of cash management-maximizing the cash availability and also the interest income-can be achieved through: Managing collections and disbursements Reliable forecasting and reporting systems Maximizing interest income by selecting the optimal mix of cash (held for transaction requirements) and marketable securities. Chapter 24 Cash Management 4 .INTRODUCTION Maximizing cash availability while simultaneously minimizing idle cash is the thrust of cash management.

MOTIVES FOR HOLDING CASH Transactionary motive Precautionary-motive Speculative-motive Chapter 24 Cash Management 5 .

In cases where the inflows precede the outflows. Lack of a perfect synchronization of inflows and outflows make cash management important. the business has to have a sufficient cash buffer to ensure that it is able to meet outflow requirements. When the outflows precede the operating inflows. Chapter 24 Cash Management 6 .CASH FLOW PROCESS AND ITS RELEVANCE Cash is the lifeblood of a business. the issue of productively parking the idle cash is of importance to the firms.

its management assumes significance for the business. while apparently non-profitable companies can be kept alive by efficient cash management techniques. Potentially profitable companies can fail because of poor cash management. Chapter 24 Cash Management 7 . This surplus also contributes towards capital servicing and future financing needs. The cash flow surplus from operating activities determines liquidity health and sustainability of operations.CASH FLOW PROCESS AND ITS RELEVANCE The operating cash flows are of utmost importance from the working capital perspective. Hence.

PRINCIPLES OF CASH MANAGEMENT The two prime objectives for the firm’s cash management system are: Holding enough cash balance to carry out the operating needs of the business Minimizing funds tied up in the idle cash balance. Chapter 24 Cash Management 8 .

the firms need to focus on the following three important aspects of cash management: Managing collections and disbursements Reliable forecasting and reporting system Maximizing the interest income by selecting the optimal mix of cash and marketable securities.PRINCIPLES OF CASH MANAGEMENT To achieve these twin objectives. Chapter 24 Cash Management 9 .

To ensure quick collections the firm should take the entry points closer to the customers. Chapter 24 Cash Management 10 . Quick collection helps the firms not only in shortening their working capital cycle but also in reducing their collection float. It is important to convert the collected funds into usable funds as quickly as possible.COLLECTIONS AND DISBURSEMENTS MANAGEMENT Cash management focuses prominently on maximizing the availability of cash through quick collections and slow disbursements.

Chapter 24 Cash Management 11 . and transfer the collected funds into centralized pool quickly.COLLECTIONS AND DISBURSEMENTS MANAGEMENT For this the firm should reduce the internal processing float. To maximize the availability of collected funds firms should try to delay disbursements up to the point it does not adversely affect relationships with suppliers.

This facilitates proper resource planning. as cash forecasting involves projections of all possible cash flows expected during the forecast periods. Chapter 24 Cash Management 12 .CASH FORECASTING A reliable system of cash forecasting helps in identifying the amounts of cash surpluses and deficits along with the periods in which they fall. An accurate forecasting system forms the bedrock of effective cash management.

Chapter 24 Cash Management 13 . The starting point of cash forecasting is the sales projections. and personnel prepare their respective budgets. marketing.CASH FORECASTING Cash forecasting is an integrated exercise that requires information from different sources/ departments. the other departments like production. which are eventually integrated into the overall cash forecast for the firm. In the light of these projected sales.

Chapter 24 Cash Management 14 . depending upon the requirements. Both short-duration and long-duration forecasts should correspond with each other. The process of moving from forecasts of shorter duration to those of longer duration is known as scheduling.CASH FORECASTING The time horizon for forecasting may range from one day to one year. while the process of moving from long-duration forecasts to short-duration forecasts is known as distribution.

CASH VS MARKETABLE SECURITIES Determining the optimal cash balance assumes significance as cash is the most liquid but least productive current asset. A high level of working balance reduces the transaction costs but increases the opportunity cost. The key issue is to determine the mix of cash held as working balance and cash invested in marketable securities. Chapter 24 Cash Management 15 .

CASH VS MARKETABLE SECURITIES The issue of optimal level of working balance is resolved in the light of tradeoff of opportunity costs and transaction costs. Chapter 24 Cash Management 16 .

Models The models to determine the optimal working balance of a firm can be classified into two categories— certainty-based models and uncertainty-based models. Chapter 24 Cash Management 17 . Certainty-based models follow the EOQ approach of inventory management while uncertainty-based models follow the stochastic modeling.CASH VS MARKETABLE SECURITIES .

the objective function of the Baumol model is of cost minimization. Like the EOQ model. Chapter 24 Cash Management 18 .Baumol Model Baumol Model uses the EOQ method of inventory control to determine the optimal level of working balance under conditions of uncertainty.

This will be done at the point where the opportunity cost is equal to the transaction cost. As per the model the optimal working balance (C) can be calculated as: C = 2 bT K 19 Chapter 24 Cash Management .Baumol Model The objective function is to minimize the total cost.

The firm’s cash balance is allowed to fluctuate between the upper control limit and the lower control limit. Following the control limits approach. the Miller–Orr model provides two control limits – the upper control limit and – the lower control limit – as well as a return point. Chapter 24 Cash Management 20 .Miller-Orr Model The Miller–Orr model adopts the stochastic approach to decisions regarding the optimal working balance.

Purchase or sale of marketable securities takes place only when one of these limits is reached.Miller-Orr Model No transaction is needed. till the cash balance fluctuates between the upper control limit and the lower control limit. as per the model. The Return Point (R) is calculated as follows: R (Return Point) = L + Chapter 24 Cash Management 3 3 bs 2 4K 21 .

The upper control limit (H) is defined as follows: H (Upper Control Limit) = 3R + L Chapter 24 Cash Management 22 .Miller-Orr Model The Lower Control Limit (L) is set by the management based on the past cash flow pattern and expected future requirements.

Miller-Orr Model Graphical View Chapter 24 Cash Management 23 .

Miller-Orr Model As can be seen in the previous figure. when the firm’s cash balance touches the upper limit on day t5. i. Similarly.e. the firm undertakes investment transactions and buys marketable securities to the tune of (H-R).. disinvestment of marketable securities takes place to the tune of (R-L). Chapter 24 Cash Management 24 . when the firm’s cash flow touches the lower limit on day t2. the Return Point (R). Such a transaction brings the cash balance of the firm back to the normal level.

Miller-Orr Model Such investment transactions bring the firm back to a normal level of cash balance. For the rest of the days no investment or disinvestment transaction gets triggered. as the firm’s working balance is within the upper and the lower control limits. Chapter 24 Cash Management 25 .. the Return Point (R).e. i.

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