CHAPTER TWO

CASH MANAGEMENT

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, receivable, and inventory get eventually converted
into cash. This underlines the significance of the cash management.

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 checks, drafts (an order by
one bank telling another bank, usually in another country, to pay money to someone) and demand
deposits (Checking accounts that pay no interest and can be withdrawn upon demand) in banks. The
broad view of cash also includes near-cash assets, such as marketable securities and time deposits (a
deposit of money for a fixed period, during which it cannot be withdrawn) in banks. The main
characteristics of these are that they can be readily sold and converted into cash. They serve as a short-
term investment outlay for excess cash and are also useful for meeting planned outflow of funds. Here
the term cash management is employed in the broader sense.

The following are some activities that are increases or decreases the cash balance

Activities that increases cash balance Activities that decrease cash balance
(Cash Inflow) (Cash outflow)
 Increasing long- term debt  Decreasing long- term debt
 Increasing equity(selling some stocks)  Decreasing equity
 Increasing current liabilities  Decreasing current liabilities
 Decreasing current assets other than  Increasing current assets other than
cash cash(buying some inventories etc)
 Decreasing fixed assets (selling assets)  Increasing fixed assets (purchase
Building, Furniture etc.)
Motives for Holding Cash (Reasons for Holding Cash)
There are three primary motives (Reasons) for maintaining cash balance:
1. Transaction Motive;
2. Precautionary Motive (Contingency needs)
3. Speculative Motive (opportunity needs)
Transaction Motive: An important reason for maintaining cash balance is the Transaction Motive.
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 firm enters into a variety of transactions to
accomplish it objectives which have to be paid for in the form cash. For example, cash payments have
to be made for purchase, wages, operating expenses, financial charges like interest, taxes, dividends,
and so on. Similarly, there is a regular inflow of cash to the firm from the sales operations returns on
outside investment, and so on.

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Precautionary Motive: In addition to the non-coincide of anticipated cash receipt and payments in
the ordinary course of business, a firm may have to pay cash for purposes which cannot be predicted
or anticipated. The unexpected cash need at short notice may be result of:
* Flood, strikes and failure of important customer;
* 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 balance held in reserve for such random and unforeseen fluctuations in cash flows are called
as precautionary balances. In other words, precautionary motive of holding cash implies the need to
hold cash to meet unpredictable obligations.
Speculative Motive: It refers to the desire of a firm to take advantage of opportunities which
represent themselves at unexpected moments and which are typically outside the normal course of
business. While the precautionary motive is defensive in nature in that firms must make provision
to tide over unexpected contingencies, the speculative motive represents a positive and aggressive
approach. Firms aim to exploit profitable opportunities and keep cash in reserve to do so. The
speculative motive help to take advantage of:
* An opportunity to purchase raw materials at 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 purchase of raw materials on the anticipation of decline in prices and
* Make purchase at favorable prices.
Of the three primary motive of holding cash balance, the most important one is the Transaction
Motive. Business firms normally do not speculate and need not have speculative balances. The
requirement of precautionary balance can be met out of short- term borrowings.
Benefit of Holding Adequate (Sufficient) Cash Balance
The important advantages of holding adequate cash balances are:
* It prevents insolvency or bankruptcy arising out of the inability of a firm to
meet its obligations.
* The relationship with the bank is not strained (worried).
* It helps in developing good relations with trade creditors and supplier of raw
material, as prompt payment may help their own cash management.
* A cash discount can be availed, if its payment is made within the due date.
* It leads to a strong credit rating which enables the firm to purchase goods on
favorable terms and to maintain its line of credit with banks and other sources of
credit.
* To take an advantage of favorable business opportunities that may be available
periodically and finally.
* The firm can meet unanticipated cash expenditure with a minimum of strain.
Keeping large cash balance, however, implies a high cost.

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Objectives of cash Management
The basic objectives of cash management are two- fold:
(a) Meeting payment
(b) Minimizing Funds Committed to Cash Balance

Meeting payment: In the normal course of business, firms have to make payments of cash on a
continuous and regular basis to suppliers of goods, employees and so on. At the same time, there is a
constant inflow of cash through collections from accounts receivables. A basic objective of cash
management is to meet the payment schedule, that is, to have sufficient cash to meet the cash
disbursement needs of a firm.
Minimizing Funds Committed to Cash Balance: The second objective of cash management is to
minimize cash balances. In minimizing cash balance, two conflicting aspects have to reconcile. A high
level of cash balances will, as shown above, ensure prompt payment together with all the advantages.
But it also implies that large funds will remain idle, as cash is non earning asset and the firm will
have to fore go profits. A low level of cash balance, on the other hand, may mean failure to meet the
payment schedule. The aim of cash management, therefore, should to have an optimal amount of
cash balances.

Estimating Cash Balances

The key purpose of cash management is to hold optimal balance of cash that is just enough to meet
the demand for cash. Cash balance more than the optimum level will cost the firm‟s profitability,
whereas cash balance that is below the optimum level will result in poor liquidity. Thus, the crux of
cash management is to determine the level of cash which will provide sufficient liquidity without
adversely affecting profitability. Management‟s goal should be to maintain levels of transactional
cash balances and marketable securities investments that contribute to improving the value of the
firm. If levels of cash are too high, the profitability of the firm will be lower than if more optimal
balance were maintained. Firms can use quantitative models to determine the optimum cash balances.

Quantitative Models

Two quantitative models that management can use to determine the optimum cash balances are the
Baumol model and the Miller-Orr model.

1. Baumol Model

William J. Baumol for the first time adopted the inventory economic order quantity model for cash
management in 1952. The model is popularly known as the Baumol‟s model.

The Baumol model is a simple approach that provides for cost-efficient transactional cash balances by
determining optimal cash conversion quantity, that is, the optimal amount of cash that should be
transferred from marketable securities to cash each time a conversion is made. It assumes that the
demand for cash can be predicted with certainty and determines the optimum cash balance or
economic conversion quantity (ECQ). It treats cash as inventory item, the future demand of which for
settling transactions can be predicted with certainty. Baumol‟s cash management model helps in

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determining a firm‟s optimum cash balance under certainty. A portfolio of marketable securities acts
as a reservoir for replenishing cash balances. The firm manages this cash on the basis of the cost of
converting marketable securities into cash (transaction cost) and the cost of holding cash rather than
marketable securities (opportunity cost).

Most firms try to minimize the sum of the cost of holding cash and the cost of converting marketable
securities to cash. As per the model, cash and inventory management problems are one and the same.

There are certain assumptions that are made in the model. They are as follows:

i) The firm is able to forecast its cash requirements with certainty and receive a specific
amount at regular intervals.
ii) The firm‟s cash payments occur uniformly over a period of time, i.e., a steady rate of cash
outflows.
iii) The opportunity cost of holding cash is known and does not change over time.
iv) The firm will incur the same transactional cost whenever it converts securities to cash.

Let us assume that the firm sells securities and starts with a cash balance of C birr. When the firm
spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its money
by selling marketable securities. As the cash balance decreases gradually, the average cash balance
will be: C*/2. This can be shown in the following figure:

C*/2 Average Cash Balance

0 T1 T2 T3 Time

Fig. 6.1 Baumol Model for cash balance

Opportunity Cost: is the interest earnings per birr given up during a specified time period as a result
of holding funds in a non-interest earning cash account rather than having them invested in interest
earning marketable securities. This cost is the cost of holding cash instead of investing the cash in
marketable securities. Thus, the firm incurs a holding cost for maintaining the cash balance. It is
known as opportunity cost, the return inevitable on the marketable securities. If the opportunity cost
is k, then the firm‟s holding cost for maintaining an average cash balance is as follows.
Holding Cost = k (C*/2)
Where: k = the opportunity (in decimal form)
C*= the optimal amount of conversion (optimum cash
balance)
C*/2 = the average cash balance

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Transaction Cost (Conversion Cost): Whenever the firm converts its marketable securities to cash, it
incurs a cost known as transaction cost. This includes the fixed cost of placing and receiving an order
for cash in the amount of the optimal cash balance (C*). It includes the cost of communicating the
necessity to transfer funds from marketable securities to the cash account, associated paper work
costs, and the cost of any follow up action. The conversion cost is stated as birr per conversion.

Total number of  Total Funds Required (T)

transaction Optimal Cash Balance(C*)

The assumption here is that the cost per transaction is constant. If the cost per transaction is c, then
the total transaction cost will be:

Transaction cost = Cost per transaction x Total # of transaction

= c x (T/C*)

The optimal cash balance (C*) is the balance that will minimize the total cost of managing cash. This
optimum balance is the amount that will be converted from marketable securities as the balance of
cash at hand is depleted. Thus, this optimum cash balance is also known as the economic conversion
quantity (ECQ), i.e., the optimum amount to be transferred from marketable securities to cash
whenever conversion or cash is to be made.

Total cost: is the sum of the total conversion and total opportunity costs.

Total cost = Holding cost + Transaction cost

Total cost = k (C*/2) + c (T/C*)

Optimum Level of Cash Balance

As the demand for cash, „C‟ increases, the holding cost will also increase and the transaction cost will
reduce because of a decline in the number of transactions. Hence, it can be said that there is a
relationship b/n the holding cost and the transaction cost.

The optimum cash balance, C* is obtained when the total cost is minimum. When we solve the total
cost equation shown above to determine the level of C* where total cost is minimum, we get the
following equation for C*:

C* = 2xcxT Where: C* = the optimal amount of conversion

k T = the total cash needed during the year.
c = cost per conversion.
k = the opportunity cost of holding cash
balance

With the increase in the cost per transaction and total funds required, the optimum cash balance will
increase. However, with an increase in the opportunity cost, it will decrease.

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Example: the management of Hake Sport, a small distributor of sporting goods, anticipates Br.
1,500,000 cash outlays (demand) during the coming year. A recent study indicates that it costs Br. 30
to convert marketable securities to cash. The marketable securities portfolio currently earns an 8%
annual rate or return.

Required: Compute
a) The optimum cash conversion balance (C*)
b) The number of conversions
c) The average cash balance
d) The total cost

Solution:

a. C* = 2 x Conversion cost x demand for cash

Opportunity cost (in decimal form)

= 2 x 30 x 1,500,000
0.08
= Br.33,541
b. The number of conversion during the year to replenish the account
= T/C*
= 1,500,000/33,541 = 45
c. The average cash balance
= C*/2 = Br.33,541/2 = Br.16,770.50
d. The cost of managing the cash is:
Total cost = k (C*/2) + c (T/C*)
= (0.08 x 16,770.50) + (Br.30 x 45) = Br. 2,692

2. The Miller-Orr Model

The Miller-Orr (MO) model is considered by many as more realistic model for cash management as
compared to Baumol‟s model since it allows the fluctuation in cash balance from time to time. It is an
improvement of Baumol‟s model in some aspect but with its own new features as well. The model
was developed by Merton Miller and Daniel Orr in the early 1960S, hence the name Miller-Orr model.

The MO model overcomes Baumol‟s shortcoming and allows for daily cash flow variation. It assumes
that firm‟s cash flows vary randomly over a planning period with normal distribution of zero mean
and a given standard deviation. As shown in Figure 6.2, the MO model provides for two control
limits – the upper control limit and the lower control limit as well as a return point. If the firm‟s cash
flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come
back to a normal level of cash balance (the return point). Similarly, when the firm‟s cash flows
wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance back
to the normal level (the return point).

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 Cash balance

Upper limit

Purchase of securities

Return point

Sale of securities
Lower limit

Time

Fig.6.2: Miller-Orr model

The firm sets the lower control limit as per its requirement of maintaining minimum cash balance.
The difference between the upper limit and the lower limit depends on the following factors:

 The transaction cost (c)

 The interest rate, (k)
 The standard deviation () of net cash flows.

The formula for determining the distance between upper and lower control limits (called Z) is as
follows: = 3 x Transaction Cost x Variance of daily Cash flow 1/3
4 x daily opportunity cost (in decimal form)

Z = 3 x c 2 1/3

4xk

Note: 1) Z will be larger if transaction cost is higher or cash flows show greater fluctuation

2) The gap b/n the two limits will come closer as the interest rate increases, i.e., Z is inversely
related to the interest rate.

 Upper Limit = Lower Limit + 3Z

 Return Point = Lower Limit + Z. This is the optimum (target) cash balance.
 Average Cash Balance = Lower Limit + 4/3Z

The MO model is more realistic since it allows variation in cash balance within lower and upper
limits. The financial manager can set the lower limit according to the firm‟s liquidity requirement.
The past data of the cash flow behavior can be used to determine the standard deviation of net cash
flows. Once the upper limit and lower limits are set, managerial attention is needed only if the cash
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balance deviate from the limits. The action under these situations are anticipated and planned in the
beginning.

Example: Continuing with the prior example, the management of Hake Sport sets the minimum cash
balance of Br. 1,000. The cost that converts marketable securities (MSS) to cash is Br.30; the firm‟s MSS
portfolio earns an 8% annual return. The variance of Hake Sport‟s daily net cash flows is estimated to
be Br. 27,000.

Required: Compute
a) the distance b/n the Upper and the Lower Limits (Z).
b) the Upper limit
c) average cash balance and the target cash balance.
d) Return point

Solution:

a) Z= 3 x c 2 1/3
4xk

= 3 x Br.30 x Br. 27,000 1/3

4 x 0.022%
= Br. 1,399

b) Upper Limit = Lower Limit + 3Z

= Br. 1,000 + (3 x 1,399)
= Br. 5,197
c) Average Cash Balance = Lower Limit + 4/3Z
= Br. 1,000 + 4/3 x 1,399
= Br. 2865.33
d) Target Cash Balance (Return point) = Lower Limit + Z
= Br. 1,000 + 1,399
= Br. 2,399

Cash Management Techniques

To minimize the firms financial requirements; financial managers attempt to speed collections and
delay disbursements.

Float

Float is the difference between the bank balance (also called available balance) and the book balance
of an account holder. In the broader sense, float refers to funds that have been dispatched by a payer
(the firm or individual making payment) but are not yet in a form that can be spent by the payee (the
firm or individual receiving payment). Float also exists when a payee has received funds in a
spendable form but these funds have not been withdrawn from the account of the payer. Delays in
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the collection – payment system resulting from the transportation and processing of checks are
responsible for float. With electronic payment system float will disappear. However, financial
managers must continue to understand and take advantage of float until that time.

Types of Float

There are two types of float. They are discussed below.

1. Collection float: results from the delay between the time when a payer or customer deducts a
payment from its checking account ledger and the time when the payee or vendor actually
receives these funds in a spendable form. Thus, collection float is experienced by the payee
and is a delay in the receipt of funds.

Checks received by the firm create collection float. Collection float increases
book balances but does not immediately change bank balances.

Example-Suppose XY CO. receives a check from a customer for Br 100,000 on Oct. 8. Assume
that the company has Br. 200,000 deposited in its bank and a zero float. The company deposits
and increases its book balance by Br. 100,000 to Br. 300,000. However, the additional cash is not
available to XY Co. until its bank has presented the check to the customer‟s bank and received
Br. 100,000. This will occur, say, on October 14. In the mean time, the cash position at XY Co.
will reflect a collection float of Br. 100,000.

Before October 8, XY‟s position is:

Float = firm‟s bank balance - firm‟s book balance

0 = Br. 200,000 – Br. 200,000

From October 8 to October 14; XY‟s position is:

Collection float = firm‟s bank balance – firm‟s book balance
=200,000-300,000
= -100,000

2. Disbursement float: results from the lapse between the time when a firm deducts a payment
from its account ledger (disburse it) and the time when funds are actually withdrawn from its
account. Disbursement float is experienced by the payer and is a delay in the actual
withdrawal of funds.

Checks written by the firm generate disbursement float, causing a decrease in

its book balance but no change (until sometime in the future) in its bank
balance.

Example – ABC Co. currently has Br. 100,000 on deposit with its bank. On June 8, it bought some
raw materials and pays with a check for Br. 100,000. The company‟s book balance is immediately
reduced by Br. 100,000 as a result. ABC‟s bank, however, will not find out about this check until it
is presented to ABC‟s bank for payment, say, on June 14. Until the check is presented, the firm‟s
bank balance is greater than its book balance by Br. 100,000.
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 That is, before June 8, there was no float.

From June 8 to June 14, disbursement float = Firm‟s bank bal. – Firm‟s book bal.
= 100,000 – 0
= 100,000

In general, a firm’s disbursement or payment activities generate disbursement float and its
collection activities generate collection float. The net effect, i.e., the sum of disbursement float
and collection float is the net float. The net float at a point in time is the overall d/c b/n the firm‟s
available balance and its book balance. If the net float is positive, then the firm‟s disbursement
float exceeds its collection float and its available balance exceeds its book balance. If the available
balance is less than the book balance, then the firm has a net collection float.

Components of Float

Both collection float and disbursement float have the same three basic components:

1. Mail float: the delay b/n the time when a payer places payment in the mail and the time
when it is received by the payee. Mail float refers to the money tied up in the mailing
process.
2. Processing float: the delay between the receipt of a check by the payee and the deposit of
it in the firm’s account. Processing float refers to funds received by the firm but not yet
deposited at its bank.
3. Clearing float: the delay b/n the deposit of a check by the payee and the actual
availability of the funds. This component of float is attributable to the time required for a
check to clear the banking system.

Speeding up Cash Collections

The firm‟s objective is not only to stimulate customers to pay their accounts as promptly as possible
but also to convert their payments into a spendable form as quickly as possible- in other words, to
minimize collection float. Some of the techniques to speeding up collections are:

1. Lockboxes. A lockbox is simply a post office address handled by the firm’s bank. In a lockbox
system, the firm bills its customers with instructions to mail payments to a post office box in a
designed city. The firm authorizes a local bank (called a lockbox bank) to collect checks from the
box and process them through the bank‟s clearing system, notifying the firm of the payments.
At time of deposit, the clearing process begins, resulting in lower processing float because the
checks are being deposited before the firm‟s accounting department processes the payments.
This collection procedure in which payers send their payments to a nearby post office box that is
emptied by the firm‟s bank several times daily, and the bank deposits the payment checks in the
firm‟s account, reduces collection float by shortening processing float as well as mail and
clearing float.
2. Concentration banking system. In this system, the firm collects payments itself, through flied
sales offices or the like. Like lockboxes, this system has the advantage of placing collection

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 centers close to the customers, thereby reducing mail float. Payments received by the sales
offices are recorded and then deposited at a local (called a depository bank). These are more
likely to be banks since field officers are often in small cities. Funds collected and deposited in
depository banks are transferred to the firm‟s concentration banks. This reduces collection float
by shortening mail and clearing float.
3. Direct send: a collection procedures in which the payee presents payment checks directly to the
banks on which they are drawn, thus reducing clearing float.
4. Preauthorized checks. Are checks written against a customer‟s checking account for a previously
agreed upon amount by the firm to whom it is payable. Because the check has been legally
authorized by the customer, it does not require the customer‟s signature. The payee merely
issues and then deposits the preauthorized check in its account. The check then clears through
the banking system just as if it were written by the customer and received and deposited by the
firm.
5. Wire transfer. Transfer of money electronically could minimize or even eliminate floats.

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