CHAPTER NO.

II
THEORETICAL BACKGROUND

MOTIVES FOR HOLDING CASH

The Transaction Motives:
The transaction motive requires a firm hold cash to conduct its business in the ordinary course.
The firms need cash primarily to make payment for purchases, wages, operating expenses, taxes,
dividends etc. A firm needs a pool of cash because its receipts and payments are not perfectly
synchronized. A pool of cash is also known as ‘transaction balance’. A cash budget is often used
to decide what the transaction balance should be.

The precautionary motive:

The precautionary motive is to hold cash to meet any contingencies in future. It provides a cushion
or buffer to withstand some unexpected emergency. The precautionary amount of cash depends
upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will
be maintained against an emergency. On other hand, unpredicted the cash flows, the larger the
need for such balances.

The speculative Motives:

The financial manager would like to take advantage of unexploited opportunities. Some reserve of
money is always essential to enable the firm to take advantage of cash when such opportunities
arise. The speculative motives 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. Three primary motives of holding
cash balance, the two of them are important viz.: the transaction motive and the precautionary
motive. Business firm normally do not speculate and need not have speculative balances. The firm
must decide the quantum of transitions and precautionary balance to be held. This depends upon
the following factors. The expected cash inflows and outflows based on the cash budget and
forecasts, encompassing long and short term cash requirements of the firm. The degree of deviation
between the expected and actual net cash flows. The firm’s ability to borrow at short notice, in the
event of any emergency. The philosophy of management regarding liquidity and risk of
insolvency. All these factors, analyses together, will determine the appropriate level of the
transactions and precautionary balances.

FACETS OF CASH MANAGEMENT

Cash management is concerned with the managing of:
 Cash flows into and out of the firm

 Cash flows within the firm

 Cash balances held by the firm

At a point of time by financing deficit or investing surplus cash. Sales generate cash which has to
be disbursed out. The surplus cash has to be invested while deficit has to be borrowed. Cash
management seeks to accomplish this cycle at a minimum cost. At the same time, it also seeks to
achieve liquidity and control. Cash management assumes more importance than other current
assets because cash is the most significant and the least productive asset that a firm holds. It is
significant because it is used to pay the firm’s obligations. However, cash is unproductive. Unlike
fixed assets or inventories, it does not produce goods for sale.

Therefore, the aim of cash management is to maintain adequate control over cash position to keep
the firm sufficiently liquid and to use excess cash in some profitable way. Cash management is
also important because it is difficult to predict cash flows accurately, particularly the inflows, and
there is no perfect coincidence between the inflows and outflows of cash. During some periods,
cash outflows will exceed cash inflows, because payment of taxes, dividends, or seasonal
inventory builds up. At other times, cash inflow will be more than cash payments because there
may be large cash sales and debtors may be realized in large sums promptly. Further, cash
management is significant because cash constitutes the smallest portion of the total current assets,
yet management’s considerable time is devoted in managing it. In recent past, a number of
innovations have been done in cash management techniques. An obvious aim of the firm these
days is to manage its cash affairs in such a way as to keep cash balance at a minimum level and to
invest the surplus cash in profitable investment opportunities.

Optimum Utilisation of Operating Cash

Implementation of a sound cash management programmed is based on rapid generation, efficient
utilisation and effective conversation of its cash resources. Cash flow is a circle. The quantum and
speed of the flow can be regulated through prudent financial planning facilitating the running of
business with the minimum cash balance. This can be achieved by making a proper analysis of
operative cash flow cycle along with efficient management of working capital.

Cash Forecasting
Cash forecasting is backbone of cash planning. It forewarns a business regarding expected cash
problems, which it may encounter, thus assisting it to regulate further cash flow movements. Lack
of cash planning results in spasmodic cash flows.

Cash Management Techniques:

Every business is interested in accelerating its cash collections and decelerating cash payments so
as to exploit its scarce cash resources to the maximum. There are techniques in the cash
management which a business to achieve this objective.

Liquidity Analysis:
The importance of liquidity in a business cannot be over emphasized. If one does the autopsies of
the businesses that failed, he would find that the major reason for the failure was their inability to
remain liquid. Liquidity has an intimate relationship with efficient utilisation of cash. It helps in
the attainment of optimum level of liquidity.

Profitable Deployment of Surplus Funds

Due to non-synchronization of ash inflows and cash outflows the surplus cash may arise at certain
points of time. If this cash surplus is deployed judiciously cash management will itself become a
profit center. However, much depends on the quantum of cash surplus and acceptability of market
for its short-term investments.

Economical Borrowings
Another product of non-synchronization of cash inflows and cash outflows is emergence of deficits
at various points of time. A business has to raise funds to the extent and for the period of deficits.
Raising of funds at minimum cost is one of the important facets of cash management. The ideal
cash management system will depend on the firm’s products, organization structure, competition,
culture and options available. The task is complex, and decisions taken can affect important areas
of the firm. For example, to improve collections if the credit period is reduced, it may affect sales.
However, in certain cases, even without fundamental changes, it is possible to significantly reduce
cost of cash management system by choosing a right bank and controlling the collections properly.

FUNCTIONS OF CASH MANAGEMENT

In order to resolve the uncertainty about cash flow prediction and lack of synchronization between
cash receipts and payments, the firm should devlope some strategies for cash management.
Efficient cash management requires proper cash planning, an organisation for managing receipts
and disbursement, and an efficient control and review mechanism. The firm should evolve
strategies regarding the following four function of cash management:

Cash planning
Cash planning can help anticipate future cash flows and needs of the firm and reduces the
possibility of idle cash balances and cash deficits. Cash planning is a technique for planning and
controlling the use of cash. Cash plans are very crucial in developing the overall operating plans
of the firm. Cash planning may be done on daily, weekly or monthly basis. The period and
frequency of cash planning generally depends upon the size of the firm and philosophy of
management. Cash budget should be prepared for this proposes.

In the words of Van Horne:

“A cash budget is a summary statement of the firm’s expected cash inflows and outflows over a
projected time period. It gives information on the timing and magnitude of expected cash flows
and cash balances over the projected period. The information helps the financial manager to
determine the future cash needs of the firm, plan for financing of these needs, and exercise control
over the cash and liquidity of the firm”. Cash forecasts are needed to prepare cash budget. Cash
forecasting may be done on a short-term or long-term basis. It is comparatively easy to make short-
term forecasts. Short-terms cash forecasts, routinely prepared by business firms, are helpful in:
 Estimating cash requirements

 Planning short-term financing

 Scheduling payments in connection with capital expenditure projects

 Planning purchases of materials

 Developing credit policies

 Checking the accuracy of long –term forecasts.

Long-term cash forecasts are generally prepared for a period ranging from 2 to 5 years and serve
to provide a rough picture of firm’s financing needs and availability of investable surplus in future.
Long-term cash forecasts are helpful in:

 Planning the outlays on capital expenditure projects

 Planning the rising of long-term funds.

Managing the cash flows:
The twin objectives in managing the cash flows are: cash inflows and cash outflows. The inflows
of cash should be accelerated while, as far as possible, the out flow of the cash should be
decelerated. A firm can conserve cash and reduce its requirements for cash balances, if it can speed
up its cash collections. Cash collections can be accelerated by reducing the lay or gap between the
time a customer pays his bills and the time the cheque is collected and funds become available for
the firms use.
Within this time gap, the delay is caused by the mailing time, e.g., the time taken by cheque in
transit and the processing time, e.g., the time taken by the firm processing cheque for internal
accounting purpose. The amount of cheques sent by customers but not yet collected is called
deposit floats. The greater will be the firm’s deposit float, the longer the time taken in converting
cheques into usable funds. In India, these floats can assume sizeable proportions, as cheques
normally take a longer time to go realised, than in most countries. An efficient financial manager
will attempt to reduce the firm’s deposits float by speeding up the mailing, processing and
collections time. There are mainly two techniques which can be used to save mailing and
processing times decentralized collections and lock box system. In decentralisation collection
system affirm sets up collection centers in various marketing centers of the country instead of a
single collection center.

The customers are instructed to remit their payments to the collection center of their region. The
collection center deposits the cheques in the local bank. These cheques are collected quickly
because many of them originate in the very city in which the bank is located. Surplus money of
the local bank can then be transferred to the company’s main bank. Another technique of speeding
up mailing processing and collection times is ‘Lock Box System’. In this system, the local post
office box is rented by the company in a city and customers of the nearby area are asked to send
their remittances to it. Local bank is authorised to pick up remittances from the box and deposit
them in the account of the company, ultimately to be transferred to the central bank account of the
company. It may be concluded that the major advantage of accelerating collections is to reduce the
firm’s total financing requirements.
Determining the optimum cash balance:
One of the primary responsibilities of the financial manager is to maintain a sound liquidity
position of the firm so that dues may be settled in time. The test of liquidity is really the availability
of cash to meet the firm’s obligations when they become due. Thus, cash balance is maintained for
day to day transactions and an additional amount may be maintained as a buffer or safety stock.
The financial manager should determine the appropriate amount of cash balance. Such a decision
is influenced by a tradeoff between risk and return. If the firm maintains a small cash balance, its
liquidity position becomes week and suffers from a paucity of cash to make payments. But at the
same time a higher profitability can be attained by investing runs out of cash it may have sell its
marketable securities, released funds in some profitable opportunities.

When the firm runs out of cash it may have to sell its marketable securities, if available, or borrow.
This involves transaction costs. On the other hand, if the firm maintains cash balance at a high
level, it will have a sound liquidity position but forgo the opportunities to earn interest. The
potential interest lost on holding large cash balance involves an opportunity cost to the firm. Thus,
the firm should maintain an optimum cash balance, neither a small nor a large cash balance. To
find out the optimum cash balance, the transaction costs and risk of too small a balance should be
matched with the opportunity costs of too large a balance. But the opportunity costs would
increase. At point x the sum of the two costs is minimum. This is the point of optimum cash balance
which a firm should seek to achieve.

Investing Idle Cash:

The idle cash or precautionary cash should be properly and profitably invested. The firm should
decide about the division of cash balances between marketable securities and bank deposits. The
management of the investment in marketable securities is an important financial management
responsibility because of the close relationship between cash and marketable securities. Therefore,
the investment in marketable securities should be properly managed. Excess cash should normally
be invested in marketable securities which can be conveniently and properly managed. Excess cash
should normally be invested in marketable securities which can be covalently and promptly
converted into cash. Cash in excess of working capital cash balance requirements of firm may
fluctuate because of the element of seasonality and business cycles. Secondly, excess cash may be
as a buffer to meet unpredictable financial needs. A firm holds extra cash because cash-flows
cannot be predicated with certainty. Cash balance held to cover the future exigencies is called the
precautionary balance ad usually is invested in marketable securities until needed. Instead of
holding excess cash for the above mentioned purpose, the firm may meet its precautionary
requirements as and when they arise by making short-term borrowings. The choice between the
short-term borrowings and liquid asset holding will depend upon the firm’s policy regarding the
mix of short-term and long-term financing.
GENERAL PRINCIPLES OF CASH MANAGEMENT:
Harry Gross has suggested certain general principles of cash management that, essentially add
efficiency to cash management. These principles reflecting cause and effect relationship having
universal applications give a scientific outlook to the subject of cash management. While, the
application of these principles in accordance with the changing conditions and business
environment requiring high degree of skill and tact which places cash management in the category
of art. Thus, we can say that cash management like any other subject of management is both
science and art for it has well-established principles capable of being skill fully modified as per
the requirements. The principles of management are follows as

Contingency Cash Requirement:

There may arise certain instances, which fall beyond the forecast of the management. These
constitute unforeseen calamities, which are too difficult to be provided for in the normal course of
the business. Such contingencies always demand for special cash requirements that was not
estimated and provided for in the cash budget. Rejections of wholesale product, large amount of
bad debts, strikes, lockouts etc. are a few among these contingencies. Only a prior experience and
investigation of other similar companies prove helpful as a customary practice. A practical
procedure is to protect the business from such calamities like bad-debt.
Determinable Variations of Cash Needs:
A reasonable portion of funds, in the form of cash is required to be kept aside to overcome the
period anticipated as the period of cash deficit. This period may either be short and temporary or
last for a longer duration of time. Normal and regular payment of cash leads to small reductions in
the cash balance at periodic intervals. Making this payment to different employees on different
days of a week can equalize these reductions. Another technique for balancing the level of cash is
to schedule I cash disbursements to creditors during that period when accounts receivables
collected amounts to a large sum but without putting the goodwill at stake.

Availability of External Cash:

Another factor that is of great importance to the cash management is the availability of funds from
outside sources. There resources aid in providing credit facility to the firm, which materialized the
firm's objectives of holding minimum cash balance. As such if a firm succeeds in acquiring
sufficient funds from external sources like banks or private financers, shareholders, government
agencies etc., the need for mash reserves diminishes.

Maximizing Cash Receipts

Every financial manager aims at making the best possible use of cash receipts. Again, cash receipts
if tackled prudently results in minimizing cash requirements of a concern. For this purpose, the
comparative cost of granting cash discount to customer and the policy of charging interest expense
for borrowing must be evaluated on continuous basis to determine the futility of either of the
alternative or both of them during that particular period for maximizing cash receipts. Yet, the
under mentioned techniques proved helpful in this context:

Concentration Banking:
Under this system, a company establishes banking centers for collection of cash in different areas.
Thereby, the company instructs its customers of adjoining areas to send their payments to those
centers. The collection amount is then deposited with the local bank by these centers as early as
possible.
Local Box System:
Under this system, a company rents out the local post offices boxes of different cities and the
customers are asked to \ forward their remittances to it. These remittances are picked by the
authorized lock bank from these boxes to be transferred to the company's central bank operated by
the head office.

Reviewing Credit Procedures:

It is aids in determining the impact of slow payers and bad-debtors on cash. The accounts of slow
paying customers should be reviewed to determine the volume of cash tied up. Besides this,
evaluation of credit policy must also be conducted for introducing essential amendments.

Minimizing Credit Period:

Shortening the terms are allowed to the customers would definitely accelerate the cash inflow side-
by-side revising the discount offered would prevent the customers from using the credit for
financing their own operations profitably.
Others:
Introducing various procedures for special handling of large to very large remittances or foreign
remittances such as, persona! Pick up of large sum of cash using airmail, special delivery and
scimitars techniques to accelerate such collections.

Minimizing Cash Disbursements:

The motive of minimizing cash payments is the ultimate benefit derived from maximizing cash
receipts. Cash disbursement can be brought under control by preventing fraudulent practices,
serving time draft to creditors of large sum, making staggered payments to creditors and for
payrolls etc.

Maximizing Cash Utilization:

Although a surplus of cash is a luxury, yet money is costly. Moreover, proper and optimum
utilization of cash always makes way for achievement of the motive of maximizing cash receipts
and minimizing cash payments. At times, a concern finds itself with funds in excess of its
requirement, which lay idle without bringing any return to it. At the same time, the concern finds
it unwise to dispose it, as the concern shall soon need it. In such conditions, efforts should be made
in investing these funds in some interest bearing securities. There are certain basic strategies
suggested by Gitman, which prove evidently helpful in managing cash if employed by the cash
management. They are: "Pay accounts payables as late as possible without damaging the firm's
credit rating, but take advantage of the favorable cash discount, if any. Collect accounts receivables
as early as possible without losing future loss sales because of high-pressure collections
techniques.

ADEQUACY OF CASH
Adequacy of cash resources has to be judged in relation to operational and liquidity requirements
of a firm. Both these functions are of great significance for smooth functioning and well-being.
Sufficiency of cash for operational requirement of a firm’s judged by computation of turnover ratio
of cash. The resultant turnover rate divided into 365, gives the number of days for which the
available cash resources were sufficient to finance the normal operational requirements of the firm.
In the word of Hunt etal:
“Financial analyst uses various liquidity ratios as through indices of the likely most widely used
ratio is the current ratios and acid test ratio.”

Professor James E. Walter:

Has proposed that instead of matching current assets with current liabilities, i.e. current ratio or
quick assets with current liabilities, i.e. quick ratio, better results can be obtained by matching
current obligations with net cash flows. In growing concern net cash flows are more important
since they are flows, whereas current liabilities only indicate the outstanding obligations on
particulars date which are continuously being replaced. In this context, he has also suggested the
computations of coverage of current liabilities ratio, which takes into account the turnover rate of
current liabilities and margin of profit on sale. Coverage of current liabilities is the product of
turnover of current liabilities and profit margin. Professor Walter calls these computations as test
actual liquidity while current and quick ratios are classified as test of only technical liquidity and
solvency.

CASH PLANNING
Cash flows are inseparable parts of the business operations of firms. A firm needs cash to invest
in inventory, receivable and fixed assets and to make payment for operating expenses in order to
maintain growth in sales and earnings. It is possible that firm may be taking adequate profits, but
may suffer from the shortage of cash as its growing needs may be consuming cash very fast.

The ‘cash poor’ position of the firm can be corrected if its cash needs are planned in advance. At
times, a firm can have excess cash with it if its cash inflows exceed cash outflows. Such excess
cash may remain idle. Again, such excess cash flows can be anticipated and properly invested if
cash planning is resorted to. Cash planning is a technique to plan and control the use of cash. It
helps to anticipate the future cash flows and needs of the firm and reduces the possibility of idle
cash balances (which lowers firm’s profitability) and cash deficits (which can cause the firm’s
failure). Cash planning protects the financial condition of the firm by developing a projected cash
statement from a forecast of expected cash inflows and outflows for a given period. The forecasts
may be based on the present operations or the anticipated future operations.

Cash plans are very crucial in developing the operating plans of the firm. Cash planning can be
done on daily, weekly or monthly basis. The period and frequency of cash planning generally
depends upon the size of the firm and philosophy of management. Large firms prepare daily and
weekly forecasts. Medium-size firms usually prepare weekly and monthly forecasts. Small firms
may not prepare formal cash forecasts because of the non-availability of information and small-
scale operations. But, if the small firm prepares cash projections, it is done on monthly basis. As
a firm grows and business operations become complex, cash planning becomes inevitable for its
continuing success.

CASH FORECASTING AND BUDGETING

Cash budget
Cash budget is the most significant device to plan for and control cash receipts and payments. A
cash budget is a summary statement of the firm’s expected cash inflows and outflows over a
projected time period. It gives information on the timing and magnitude of expected cash flows
and cash balances over the projected period. This information helps the financial manager to
determine the future cash needs of the firm, plan for the financing of these needs and exercise
control over the cash and liquidity of the firm. The time horizon of the cash budget may differ
from firm to firm. A firm whose business is affected by seasonal variations may prepare monthly
cash budgets.

Cash forecasts
Cash forecasts are needed to prepare cash budgets. Cash forecasting may be done on short or long-
term basis. Generally, forecasts covering periods of one year or less are considered short-term;
those exceeding beyond one year are considered long term.

SHORT-TERM CASH FORECASTS

It is comparatively easy to make short-term cash forecasts. The important functions of carefully
developed short-term cash forecasts are:
  To determine operating cash requirements

 To anticipate short-term financing

 To manage investment of surplus cash.

The short-term forecast helps in determining the cash requirements for a predetermined period to
run a business. If the cash requirements are not determined, it would not be possible for the
management to know-how much cash balance is to be kept in hand, to what extent bank financing
be depended upon and whether surplus funds would be available to invest in marketable securities.
To know the operating cash requirements, cash flow projections have to be made by a firm. As
stated earlier, there is hardly a perfect matching between cash inflows and outflows. With the
short-term cash forecasts, however, the financial manager is enabled to adjust these differences in
favor of the firm. It is well known that, for their temporary financing needs, most companies
depend upon banks. One of the significant roles of the short-term forecasts is to pinpoint when the
money will be needed and when it can be repaid. With such forecasts in hand, it will not be difficult
for the financial manager to negotiate short-term financing arrangements with banks. This in fact
convinces bankers about the ability of the management to run its business. The third function of
the short-term cash forecasts is to help in managing the investment of surplus cash in marketable
securities. Carefully and skillfully designed cash forecast helps a firm to:

 Select securities with appropriate maturities and reasonable risk.

 Avoid over and under-investing.

Short-run cash forecasts serve many other purposes. For example, multi-divisional firms use them
as a tool to coordinate the flow of funds between their various divisions as well as to make
financing arrangements for these operations. These forecasts may also be useful in determining
the margins or minimum balances to be maintained with banks. Still other uses of these forecasts
are:
  Planning reductions of short and long-term debt

 Scheduling payments in connection with capital expenditures programmers

 Planning forward purchases of inventories

 Checking accuracy of long-range cash forecasts.

 Taking advantage of cash discounts offered by suppliers

SHORT-TERM FORECASTING METHODS
Two most commonly used methods of short-term cash forecasting are:

 The receipt and disbursements method

 The adjusted net income method.

The receipts and disbursements method is generally employed to forecast for limited periods, such
as a week or a month. The adjusted net income method, on the other hand, is preferred for longer
durations ranging between few months to a year. Both methods have their pros and cons. The cash
flows can be compared with budgeted income and expenses items if the receipts and disbursements
approach is followed. On the other hand, the adjusted income approach is appropriate in showing
a company’s working capital and future financing needs.

RECEIPTS AND DISBURSEMENTS METHOD:

Cash flows in and out in most companies on a continuous basis. The prime aim of receipts and
disbursements forecasts is to summarize these flows during a predetermined period. In case of
those companies where each item of income and expense involves flow of cash, this method is
favored to keep a close control over cash. Three broad sources of cash inflows can be identified:

 Operating
  Non-operating

 Financial

Cash sales and collection from customers form the most important part of the operating cash
inflows. Developing a sales forecast is the first step in preparing cash forecast. All precautions
should be taken to forecast sales as accurately as possible. In case of cash sales, cash is received
at the time of sale. On the other hand, cash is realized after sometime if sale is on credit. The time
realizing cash on credit sales depends upon the firm’s credit policy reflected in the average
collection period. It can easily be noted that cash receipts from sales will be affected by changes
in sales volume and the firm’s credit policy. To develop a realistic cash budget, these changes
should be accounted for. If the demand for the firm’s products slackens, sales will fall and the
average collection period is likely to be longer which increases the chances of bad debts.

In preparing cash budget, account should be taken of sales discounts, returns and allowances and
bad debts as they reduce the amount of cash collections from debtors. Non-operating cash inflows
include sale of old assets and dividend and interest income. The magnitude of these items is
generally small. When internally generated cash flows are not sufficient, the firm resorts to external
sources. Borrowings and issuance of securities are external financial sources. These constitute
financial cash inflows. The next step in the preparation of a cash budget is the estimate of cash
outflows. Cash outflows include:

 Operating outflows: cash purchases, payment of payables, advances to suppliers, wages

and salaries and other operating expenses

 Capital Expenditures

 Contractual payments: repayment of loan and interest and tax payments

 Discretionary payments: ordinary and preference dividend.

  In case of credit purchases, a time lag will exist for cash payments. This will depend on the
credit terms offered by the suppliers.

It is relatively easy to predict the expenses of the firm over short run. Firms usually prepare capital
expenditure budgets; therefore, capital expenditures are predictable for the purposes of cash
budget. Similarly, payments of dividend do not fluctuate widely and are paid on specific dates.
Cash out flow can also occur when the firm repays its long-term debt. Such payments are generally
planned and, therefore, there is no difficulty in predicting them. Once the forecasts for cash receipts
and payments have been developed, they can be combined to obtain the net cash inflow or outflow
for each month. The net balance for each month would indicate whether the firm has excess cash
or deficit. The peak cash requirements would also be indicated. If the firm has the policy of
maintaining some minimum cash balance, arrangements must be made to maintain this minimum
balance in periods of deficit.

The cash deficit can be met by borrowings from banks. Alternatively, the firm can delay its capital
expenditures or payments to creditors or postpone payment of dividends. One of the significant
advantages of cash budget is to determine the net cash inflow or out flow so that the firm is enabled
to arrange finances. However, the firm’s decision for appropriate sources of financing should
depend upon factors such as cost and risk. Cash budget helps a firm to manage its cash position. It
also helps to utilize ideal funds in better ways. The virtues of the receipt and payment methods are:

 It gives a complete picture of all the items of expected cash flows.

 It is a sound tool of managing daily cash operations.

 Its reliability is reduced because of the uncertainty of cash forecasts.

 It fails to highlight the significant movements in the working capital items.

ADJUSTED NET INCOME METHOD:

This method of cash forecasting involves the tracing of working capital flows. It is sometimes
called the sources and uses approach. Two objectives of the adjusted net income approach are To
show whether the company can generate the required funds internally, and if not, how much will
have to be borrowed or raised in the capital market. To project the company’s need for cash at a
future date. As regards the form and content of the adjusted net income forecast, it resembles the
cash flow statement discussed previously. It is, in fact a projected cash flow statement based on
preformat financial statements. It generally has three sections: sources of cash, uses of cash and
the adjusted cash balance. This procedure helps in adjusting estimated earnings on an accrual basis
to a cash basis. It also helps in anticipating the working capital movements. In preparing the
adjusted net income forecasts items such as net income, depreciation, taxes, dividends etc., can
easily be determined from the company’s annual operating budget.

Normally, difficulty is faced in estimating working capital changes; especially the estimates of
accounts receivable (debtors) and inventory pose problem because they are influenced by factors
such as fluctuations in raw material costs, changing demand for the company’s products and
possible delays in collections. Any error in predicting these items can make the reliability of
forecast doubtful. One popularly used method of projecting working capital is to use ratios relating
accounts receivable and inventory to sales. For example, if the past experience tells that accounts
receivable of a company range between 32 percent to 36 percent of sales, an average rate of 34
percent can be used. The benefits of the adjusted net income method are:

 It highlights the movements in the working capital items, and thus helps to keep a control
on s firm’s working capital.

 It fails to trace cash flows, and therefore, its utility in controlling daily cash operations is
limited.

LONG-TERM CASH FORECASTING

Long-term cash forecasts are prepared to give an idea of the company’s financial requirements in
the distant future. They are not as detailed as the short-term forecasts are. 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 firm’s financial condition three, five, or more years in
the future. The major uses of the long-term cash forecasts 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.

Long-term cash forecasts may be made for two, three or five years. As with the short-term
forecasts, company’s practices may differ on the duration of long-term forecasts to suit their
particular needs. The short-term forecasting methods, i.e., the receipts and disbursements method
and the adjusted net income method, can also be used in long-term cash forecasting. Long-term
cash forecasting reflects the impact of growth, expansion or acquisitions; it also indicates financing
problems arising from these developments.

DETERMINING THE OPTIMUM CASH BALANCE

One of the primary responsibilities of the financial manager is to maintain a sound liquidity
position of the firm so that the dues are settled in time. The firm needs cash to purchase raw
materials and pay wages and other expenses as well as for paying dividend, interest and taxes. The
test of liquidity is the availability of cash to meet the firm’s obligations when they become due. A
firm maintains the operating cash balance for transaction purposes. It may also carry additional
cash as a buffer or safety stock. The amount of cash balance will depend on the risk-return trade-
off.
FEATURES OF INSTRUMENTS OF COLLECTION IN INDIA

POINTS PROS CONS

 No charge  Can bounce

 Collection times can be
 Payable through clearing
long
Cheques
 Can be discounted after
 Collection charge
receipts
 Low discounting charge
 Payable in local clearing  Cost of collection
Drafts  Chances of bouncing are  Buyers account debited on
less day one
 Not payable through
 Low discounting charge
clearing
 Theoretically, goods are
Documentar not released till payments
 High collection cost
y bills are made or the bill is
accepted
 Long delays

 No charge except stamp  Procedure is relatively

duty cumbersome
 Buyers are reluctant to
Trade bills  Can be discounted accept the due date
discipline
 Discipline of payment on
due date

OPTIMUM CASH BALANCE UNDER CERTAINTY:

BAUMOL’S 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. As such, the firm attempts to minimize the sum of the cost of holding cash
(inventory of cash) and the cost of converting marketable securities to cash. The Baumol’s model
makes the following assumptions:
 The firm is able to forecast its cash needs with certainty.

 The firm’s cash payments occur uniformly over a period of time.

 Baumol’s model for cash balance

Cash balance

C/2

Average

Time

0 T1 T2 T3

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 k, then the firm’s holding
cost for maintaining an average cash balance is as follows:

Holding cost = k(C/2) (1)

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 requirement, 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 c,
then the total transaction cost will be:

Transaction cost = c(T/C) (2)

The total annual cost of the demand for cash will be:

Total cost = k(C/2) + c(T/C) (3)

What is the optimum level of cash balance, C*? We know that the holding cost increases as the
demand for cash, C, increases. However, the transaction cost reduces because with increasing C
the number of transactions will decline. Thus, there is a trade-off between the holding cost and the
transaction cost.

Cost trade-off: Baumol’s model

Cost

Total cost

Holding cost

Transaction cost

Cash balance

OPTIMUM CASH BALANCE UNDER UNCERTAINTY:

THE MILLER-ORR MODEL
The limitation of the Baumol model is that it does not allow the cash flows to fluctuate. Firms in
practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and
outflows. The Miller-Orr (MO) model overcomes this shortcoming and allows for daily cash flow
variation. It assumes that net cash flows are normally distributed with a zero value of mean and
standard deviation. 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).
 Miller- Orr model

Cash balance

Upper limit

Purchase of securities

Return point
Sale of securities

Lower point

Time

The firm sets the lower control limit as per its requirement of maintaining minimum cash balance.
At what distance the upper control limit will be set? The difference between the upper limit and
the lower limit depends on the following factors:

 The transaction cost (c)

 The interest rate, (i)

 The standard deviation of net cash flows.

The formula for determining the distance between upper and lower control limits (called Z) is as
follows:
(Upper Limit—Lower Limit) =
(3/4 * transaction cost * cash flow variation/ interest per day)⅓ (5)
We can notice from equation (5) that the upper and lower limit will be far off from each other (i.e.
Z will be larger) if transaction cost is higher or cash flows show greater fluctuations. The limits
will come closer as the interest increases. Z is inversely related to the interest rate. It is noticeable
that the upper limit is three times above the lower control limit and the return point lies between
the upper and the lower limit. Thus,

Upper Limit = Lower Limit + 3Z (6)

Return point = Lower Limit + Z (7)

The net effect is that the firms hold the average cash balance equal to:

Average Cash Balance = Lower Limit +4/3 Z

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 and lower limits are set, managerial attention is needed only if the cash
balance deviates from the limits. The action under these situations are anticipated and planned in
the beginning.

INVESTING SURPLUS CASH IN MARKETABLE SECURITIES

There is a close relationship between cash and money market securities or other short-term
investment alternatives. Investment in these alternatives should be properly managed. Excess cash
should normally be invested in those alternatives that can be conveniently and promptly converted
into cash. Cash in excess of the requirement of operating cash balance may be held for two reasons.
First, the working capital requirements of the firm fluctuate because of the elements of seasonality
and business cycles. The excess cash may build up during slack seasons but it would be needed
when the demand picks up. Thus, excess cash during slack season is idle temporarily, but has a
predictable requirement later on. Second, excess cash may be held as a buffer to meet unpredictable
financial needs. A firm holds extra cash because cash flows cannot be predicted with certainty.
Cash balance held to cover the future exigencies is called the precautionary balance and is usually
invested in the short-term money market investments until needed. Instead of holding excess cash
for the above-mentioned purpose, the firm may meet its precautionary requirements as and when
they arise by making short-term borrowings. The choice between the short-term borrowings and
liquid assets holding will depend upon the firm’s policy regarding the mix of short-term financing.
The excess amount of cash held by the firm to meet its variable cash requirements and future
contingencies should be temporarily invested in marketable securities, which can be regarded as
near moneys. A number of marketable securities may be available in the market.

TYPES OF SHORT-TERM INVESTMENT OPPORTUNITIES

The following short-term investment opportunities are available to companies in India to invest
their temporary cash surplus:
Treasury bills
Treasury bills (TBs) are short-term government securities. The usual practice in India is to sell
treasury bills at a discount and redeem them at par on maturity. The difference between the issue
price and the redemption price, adjusted for the time value of money, is return on treasury bills.
They can be bought and sold any time; thus, they have liquidity. Also, they do not have the default
risk.

Commercial papers
Commercial papers (CPs) are short-term, unsecured securities issued by highly credit worthy large
companies. They are issued with a maturity of three months to one year. CPs are marketable
securities, and therefore, liquidity is not a problem.

Certificates of deposits
Certificates of deposits (CDs) are papers issued by banks acknowledging fixed deposits for a
specified period of time. CDs are negotiable instruments that make them marketable securities.
Bank deposits
A firm can deposit its temporary cash in a bank for a fixed period of time. The interest rate depends
on the maturity period. For example, the current interest rate for a 30 to 45 days deposit is about 3
percent and for 180 days to one year is about 6-7 percent. The default risk of the bank deposits is
quite low since the government owns most banks in India.

Inter-corporate deposits
Inter-corporate lending borrowing or deposits (ICDs) is a popular short-term investment
alternative for companies in India. Generally a cash surplus company will deposit (lend) its funds
in a sister or associate companies or with outside companies with high credit standing.

Money market mutual funds

Money market mutual funds (MMMFs) focus on short-term marketable securities such as TBs,
CPs, CDs, or call money. They have a minimum lock-in period of 30 days, and after this period,
an investor can withdraw his or her money any time at a short notice or even across the counter in
some cases. They offer attractive yields; yields are usually 2 percent above than on bank deposits
of same maturity.

CASH MANAGEMENT SERVICES GENERALLY OFFERED

The following is a list of services generally offered by banks and utilised by larger businesses and
corporations:

Account Reconcilement Services:

Balancing a checkbook can be a difficult process for a very large business, since it issues so many
checks it can take a lot of human monitoring to understand which checks have not cleared and
therefore what the company's true balance is. To address this, banks have developed a system
which allows companies to upload a list of all the checks that they issue on a daily basis, so that at
the end of the month the bank statement will show not only which checks have cleared, but also
which have not.
Armored Car Services:
Large retailers who collect a great deal of cash may have the bank pick this cash up via an armored
car company, instead of asking its employees to deposit the cash.

Advanced Web Services:

Most banks have an Internet-based system which is more advanced than the one available to
consumers. This enables managers to create and authorize special internal logon credentials,
allowing employees to send wires and access other cash management features normally not found
on the consumer web site.

Automated Clearing House:

Services are usually offered by the cash management division of a bank. The Automated Clearing
House is an electronic system used to transfer funds between banks. Companies use this to pay
others, especially employees (this is how direct deposit works). Certain companies also use it to
collect funds from customers. This system is criticized by some consumer advocacy groups,
because under this system banks assume that the company initiating the debit is correct until
proven otherwise.

Balance Reporting Services:

Corporate clients who actively manage their cash balances usually subscribe to secure web-based
reporting of their account and transaction information at their lead bank. These sophisticated
compilations of banking activity may include balances in foreign currencies, as well as those at
other banks.

Cash Concentration Services:

Large or national chain retailers often are in areas where their primary bank does not have
branches. Therefore, they open bank accounts at various local banks in the area. To prevent funds
in these accounts from being idle and not earning sufficient interest, many of these companies have
an agreement set with their primary bank, whereby their primary bank uses the Automated
Clearing House to electronically "pull" the money from these banks into a single interest-bearing
bank account.

Lockbox services:
Often companies which receive a large number of payments via checks in the mail have the bank
set up a post office box for them, open their mail, and deposit any checks found. This is referred
to as a "lockbox" service.

Positive Pay:
Positive pay is a service whereby the company electronically shares its check register of all written
checks with the bank. The bank therefore will only pay checks listed in that register, with exactly
the same specifications as listed in the register. This system dramatically reduces check fraud.

Sweep Accounts:
Are typically offered by the cash management division of a bank. Under this system, excess funds
from a company's bank accounts are automatically moved into a money market mutual fund
overnight, and then moved back the next morning. This allows them to earn interest overnight.
This is the primary use of money market mutual funds.

Zero Balance Accounting:

Can be thought of as somewhat of a hack. Companies with large numbers of stores or locations
can very often be confused if all those stores are depositing into a single bank account.
Traditionally, it would be impossible to know which deposits were from which stores without
seeking to view images of those deposits. To help correct this problem, banks developed a system
where each store is given their own bank account, but all the money deposited into the individual
store accounts are automatically moved or swept into the company's main bank account. This
allows the company to look at individual statements for each store.

Wire Transfer:
A wire transfer is an electronic transfer of funds. Wire transfers can be done by a simple bank
account transfer, or by a transfer of cash at a cash office. Bank wire transfers are often the most
expedient method for transferring funds between bank accounts. A bank wire transfer is a message
to the receiving bank requesting them to effect payment in accordance with the instructions given.
The message also includes settlement instructions. The actual wire transfer itself is virtually
instantaneous, requiring no longer for transmission than a telephone call.
Controlled Disbursement:
This is another product offered by banks under Cash Management Services. The bank provides a
daily report, typically early in the day, that provides the amount of disbursements that will be
charged to the customer's account. This early knowledge of daily funds requirement allows the
customer to invest any surplus in intraday investment opportunities, typically money market
investments. This is different from delayed disbursements, where payments are issued through a
remote branch of a bank and customer is able to delay the payment due to increased float time. In
the past, other services have been offered the usefulness of which has diminished with the rise of
the Internet. For example, companies could have daily faxes of their most recent transactions or
be sent CD-ROMs of images of their cashed checks.

PURPOSE OF CASH MANAGEMENT

Cash management is the stewardship or proper use of an entity’s cash resources. It serves as the
means to keep an organization functioning by making the best use of cash or liquid resources of
the organization. The function of cash management at the U.S. Treasury is threefold:

 To eliminate idle cash balances. Every dollar held as cash rather than used to augment
revenues or decrease expenditures represents a lost opportunity. Funds that are not needed
to cover expected transactions can be used to buy back outstanding debt or can be invested
to generate a flow of funds into the Treasury’s account.

 To deposit collections timely. Having funds in-hand is better than having accounts
receivable. The cash is easier to convert immediately into value or goods. A receivable, an
item to be converted in the future, often is subject to a transaction delay or a depreciation
of value. Once funds are due to the Government, they should be converted to cash-in-hand
immediately and deposited in the Treasury's account as soon as possible.

 To properly time disbursements. Some payments must be made on a specified or legal date,
such as Social Security payments. For such payments, there is no cash management
decision. For other payments, such as vendor payments, discretion in timing is possible.
Government vendors face the same cash management needs as the Government. They want
to accelerate collections. One way vendors can do this is to offer discount terms for timely
payment for goods sold.