Cash Management

Cash Management involves having the optimum, neither excessive nor deficient, amount of cash
on hand at the right time. Proper cash management requires that the company know how much cash it
needs, as well as how much it has and where that cash is at all times.
Cash Management involves control over the receipts and payments of cash so as to minimize
nonearning cash balances. Hence, the financial manager should actively seek to keep the nonearning
asset to a minimum. Minimizing cash balances as well as having accurate knowledge of when cash
moves into and out of the company can improve overall corporate profitability. However, a business
firm would not want to get caught without cash when it is needed.

Objective of Cash Management

The basic objective in cash management is to keep the investment in cash as low as possible
while still keeping the firm operating efficiently and effectively.
The objective of cash management is to invest excess cash for a return while retaining sufficient
liquidity to satisfy future needs. The financial manager must plan when to have excess funds available
for investment and when money needs to be borrowed
A finance manager can use the following strategies in monitoring cash balances.
1. Accelerate cash inflows by optimizing mechanisms for collecting cash
2. Monitoring the cash disbursement needs or payment schedule
3. Minimize the amount of idle cash or funds committed to transactions and precautionary
balances
4. Avoid misappropriation and handling losses in the normal course of business.

To achieve the objectives, proper planning of cash flows is needed. Effective cash management
generally encompasses proper management of cash flows which entails among others the following:
a. Improving forecast of cash flows
b. Using floats
c. Synchronizing cash inflows and outflows
d. Accelerating collections
e. Controlling disbursements
f. Obtaining additional funds when and where they are needed

Reasons for Holding Cash Balances

A business enterprise may keep part of its capital tied up in cash for several reasons.
1. Transaction Facilitation
This involves the use of cash to pay for planned business expenditures such as supplies,
payrolls, taxes suppliers’ bills, interest on debts, cash dividends and acquisitions of long-term
fixed assets.
2. Precautionary Motive
 Although the firms expects cash to come in from day-to-day operations and other
financing activities, the inflows and outflows are not usually perfectly synchronized. It will need
to keep enough cash for emergency purposes. Precautionary cash balances are more likely to
be important in seasonal or cyclical industries where cash inflows are more uncertain. Firms
with precautionary needs usually rely on unused lines of bank credit.
3. Compliance with Creditors’ Covenant
Another major reason for holding cash is to be able to comply the requirement of
lending institutions and other creditors of keeping a certain percentage of borrowed funds in
their bank accounts (e.g. compensating balance)
4. Investment Opportunities
Having excess cash may allow the firm to take advantage of investment opportunities
that would otherwise be impossible to transact.
Example:
When a block of raw materials is offered at discounted prices if purchased on cash
basis.

To determine how much cash to keep on hand, firms must know the trade-off between the opportunity
costs associated with holding too much cash against the storage costs of not having enough cash.

Determining the Target Cash Balance

The target cash balance may be derived with the use of the following approaches, namely:
1. Cash Budget
2. Cash Break-even Chart
3. Optimal Cash balance using the
a. Baumol Model
b. Miller-Orr Model
Cash Budget
The cash budget is the tool used to present the expected cash inflows and cash outflows.
Cash Receipts
These refers to all the cash received by the company. Normally, the bulk of the company’s cash
receipts come from customers. The possibility of cash and other sources (such as additional
investments, sales of assets, borrowing should likewise be considered when cash receipts are being
budgeted.
Cash Disbursements
These refers to all the payments made by the company. Data converted from individual
budgets supply the basic information for the cash disbursements budget.

Example:

XYZ Manufacturing Company

Cash Budget
For the Budget Year ended December 31, 2013
Cash balance, beginning P 150,000
Add: Estimated Receipts
Collections from Customers P 5,185,000
Sale of Assets 25,000
Total P 5,210,000
Total cash available P 5,360,000
Less: estimated Disbursements
Payment for Material Purchases P 1,164,000
Direct Labor 949,000
Manufacturing Overhead 851,000
Marketing & Administrative Expenses 1,458,000
Payments for income tax 252,000
Dividends 140,000
Reduction in long-term debt 83,000
Acquisition of new assets 320,000
Total Disbursements P 5,217,000
Cash balance, end P 143,000
=====
Cash Break-even Chart
This shows the relationship between the company’s cash needs and cash sources. It indicates
the minimum amount of cash that should be maintained to enable the company to meet its obligations.

Example:
ABC Company manufactures plastic which it sells to other industrial users. The monthly
production capacity of the company is 1,000,000 kilos. Selling price is P1 per kilo.

Its cash requirements have been determined as follows:

a. Fixed monthly payments amounting to P200,000 while
b. Variable cash payments are 50% of sales.

Required:
1. Determine the Cash Break-even point (mathematical approach)
2. Prepare a Cash Break-even Chart to project the relationship between the company’s cash
needs and cash sources.
Solution:

1. Cash Break-even Point = Fixed Monthly Payments

Sales - Variable Costs
Sales

= P200,000________
100% - 50%
100%

= P200,000
50%
= P400,000 or 400,000 kilos
Optimal Cash Balance

Cash is needed for both transactions and precautionary needs in all companies which must be
available in some form such as cash, marketable securities and borrowing capacity at all times. The
liquidity managers must utilize some formal models or techniques to maintain the optimal amount of
each moment in time because too much liquidity brings down the rate of return on total assets
employed and too little liquidity jeopardizes the very existence of the firm itself. In managing the level
of cash (currency plus demand deposits) for transaction purposes versus near cash (marketable
securities), the following costs must be considered:
1. Fixed and variable brokerage fees, and
2. Opportunity costs such as interest foregone by holding cash instead of near cash.

The Baumol Model

This is one of the model use to help determine the optimal cash balance. This model balances
the opportunity cost of holding cash against the transactions costs associated with replenishing the cash
account by selling off marketable securities by borrowing.
This model provides a useful starting point for establishing a target cash balance.
The optimal cash balance can be found by using the following variables and equations:
1. The total costs of cash balances consist of a holding (or opportunity) cost plus a transaction cost:

Total Costs = Holding costs + Transaction Costs

= (Average Cash ) (Opportunity ) + ( No. of transactions) (Cost per transaction)

( balance ) ( cost )

= C (K) + T (F)
2 C
Where:
C = amount of cash raised by selling marketable securities or by borrowing

C = average cash balance

2

C* = optimal amount of cash to be raised by selling marketable securities by borrowing

C* = optimal average cash balance

2

F = fixed costs of making a securities trade or of obtaining a loan.

 T = Total amount of net new cash needed for transactions during the period (usually a
year)

K = opportunity cost of holding cash, net equal to the rate of return foregone on marketable
securities or the cost of borrowing to hold cash.

2. The minimum costs of cash balances are achieved when C is set equal to C*, the optimal cash
replenishment level. The formula to find C* is as follows:

C* = √ 2 (Total amount of net cash required ) (¿ costs of trading securities∨cost of borrowing)

Opportunity cost of holding Cash
Or

C* = √ 2 (T ) (F)
K

Case 1. Determination of Optimal average Cash Balance for Baumol Model

Leander Company has total payments of P50,000 for one year., with a cost per transaction of P8,
and the interest rate on marketable securities is 6%. Compute for the optimal cash balance.

C* = √ 2 (Total amount of net cash required ) (¿ costs of trading securities∨cost of borrowing)

Opportunity cost of holding Cash
C* = √ 2(P 50,000)( P 8) = P3,651.48
6%

Optimal Average Cash Balance = P3,651.48 = P1,825.74

2

The Miller-Orr Model

The Miller-Orr model is another approach in calculating the optimal cash management strategy.
It assumes that the distribution of daily net cash flows is normally distributed and allows for both cash
inflows and outflows. This model bases its computations where:
L = the lower control limit
F = the trading cost for marketable securities per transaction
∂ = the standard deviation in net daily cash flows
i day = the daily interest rate on marketable securities
Z* = optimal cash return point
H* = upper control limit for cash balances

2
3
To compute for Z* = √ 3 F ∂+ L
 4i day
To compute for H*, the following formula is used:
H* = 3Z* - 2L
Note: In the Miller-Orr, Z* will be the replenishment level to which cash is replenished when the cash
level hits L, but it will also be the return level that cash is brought back down to when cash hits H*.

Case 2. Calculation of Optimal Return Point and Upper Limit for Miller-Orr Model
Suppose XYZ company Inc., would like to maintain its cash account at a minimum level of
P100,000, but expects the standard deviation in net daily cash flows to be P5,000; the effective annual
rate on marketable securities will be 8% per year, and the trading cost per sale or purchase of
marketable securities will be P200 per transaction.
Required:
Compute for the XYZ Company’s optimal cash return point and upper limit?
Solution:
i day = 8% = .00021
365 days
2
Z* = √3 3 ( 200 ) (5,000)+1000,000
____________
4 x .00021
= P126,101.72

H* = 3(126,101.72) - 2(100,000)
= 378,305.16 – 200,000
= P178,305.16
Note:
Based on the computation, the firm will reduce cash to P126,101.72 by buying
marketable securities when the cash balance gets up to P178,305.16, and it will increase cash to
P126,101.72 by selling marketable securities when the cash balance gets down to P100,000.

Other Factors Influencing the Target Cash Balance

1. Option to incur short-term borrowing to meet unexpected demands for cash. If the
probability of an unexpected demand for cash causing the firm to borrow in the
short-term is low enough, or if the amount of interest to be earned by investing in
longer-term securities is higher than that to be earned on marketable securities,
then it might be worth it for the firm to risk occasionally paying a relatively high
interest rate on short-term borrowing.
2. Transaction Costs and Time Element. Transaction costs as well as time associated
with trading securities have fallen so dramatically low that many business firms
 decide to sell marketable securities as needed in order to meet any unforeseen
demand for cash during the day.
3. Many firms must keep certain average minimum balances in their deposit accounts
as part of borrowing agreements with their bank. Some firms occasionally meet
unforeseen demand for cash that causes their deposit account to temporarily fall
below the minimum compensating balance. To offset this, they keep a
corresponding amount of excess cash in the account in a later period. This enables
them to cover up the earlier deficiency and meeting the required average minimum
balance.

Cash Management Techniques

Cash management activities are performed jointly by the firm and its depository
banks. The financial manager is responsible for the effectiveness of the cash
management program.
A major business enterprise may have several bank accounts and since it is
impractical to think that inflows and outflows will balance in each account, the finance
department should be able to develop and implement a system where funds can be
transferred from where they currently are, to where they are needed, to arranger loans,
to cover net cash shortage and to invest cash surpluses without delay.
Effective cash management encompasses the proper management of cash
inflows and outflows, which involve:
1. Synchronizing cash flows
2. Using floats
3. Accelerating cash collections
4. Getting available funds to where they are needed.
5. Controlling disbursements

Synchronizing Cash Flows

Synchronized cash flows is a situation in which inflows coincide with outflows thereby
permitting a firm to hold low transactions balances. A thorough review of the cash flow
analysis, cash conversion cycle and cash budget would be most helpful.
By improving the forecasts of cash receipts and disbursements and arranging things so
that cash receipts coincide or occur at an earlier time than the timing of required cash outflows,
firms can reduce its cash balance, bank loans will be reduced together with the corresponding
interest expense, thus boosting profits.

Using Floats
 Float is defined as the difference between the balance shown in a firm’s books and the
balance on the banks record. It arises from the delays in mailing, processing and clearing
checks through the banking system.
Once the check is received and a deposit is made, the deposited funds are not available
for use until the check has cleared the banking system (about 3 to 6 days) and credited to the
corporate bank account. This works both for checks written to pay suppliers as well as checks
deposited from customers. This means float can be managed to some extent through a
combination of disbursement and collection strategies.
To accelerate cash inflow, the financial manager must (1) know the bank’s policy
regarding fund availability (2) know the source and location of company receipts, and (3) device
procedures for quick deposit of checks received and quick transfer of receipts in outlying
accounts into the main corporate accounts.

Various Types of Check Processing Delays

1. Mail float – the time required for a check to move from a debtor to a creditor
This can be minimized by having the collection center located near the customer.
Local banks should be selected to speed up the receipt of funds for subsequent
transfer to the central corporate account.
2. Processing Float – the time it takes for a creditor to deposit the check after receipt
3. Deposit Collection Float – the time required for a check to clear

Mail float can be minimized by having the collection center located near the customer.
Local banks should be selected to speed up the receipt of funds for subsequent transfer to the
central corporate account. As an alternative, strategic post office lockboxes may be used for
customer remissions. The local bank collects from these boxes periodically during the day and
deposits the funds in the corporate account. The bank also furnishes the company with a
computer listing of payments received by account and a daily total. The lockbox system has a
significant per-item cost, it is most cost-effective with low-volume, high-peso remissions.
However, the system is becoming increasingly more available to companies with high- volume,
low-peso deposits as technological advances (such as machine readable documents) lower the
per item cost of lockboxes. Before a lockbox system is implemented, the company should make
a cost-benefit analysis that considers the average peso amount of checks received, the costs
saved by having lockboxes, the reduction in mailing time per check, and the processing cost.

Problems:
1. Delay in Cash Receipt
 Chase corporation obtains average cash receipts of P200,000 per day. It usually takes 5
days from the time a check is mailed to its availability for use. The amount tied up by
the delay is:

Solution: 5 days x P200,000 = P1,000,000

2. Lockbox
It typically takes JL corporation 8 days to receive and deposit customer remissions. JL is
considering a lockbox system and anticipates that the system will reduce the float time
to 5 days. Average daily cash receipts are P220,000. The rate of return is 10 percent.
Required:
1. What is the reduction in cash balances associated with implementing the
system?
2. What is the rate of return associated with the earlier receipt of the funds?
3. What should be the maximum monthly charge associated with the lockbox
proposal?
Solutions:
a. Reduction in cash balance
P220,000 x 3 days = P660,000
b. Rate of Return associated with the earlier receipt of the funds
.10 x P660,000 = P66,000
c. Maximum monthly charge
P66,000/12 = P5,500
4. Book balance versus Bank Balance
Company B writes checks averaging P30,000 per day that require 4 days to clear. By what
amount will its book balance be less than its bank balance?
Solution:
P30,000 x 4 days = P120,000

Disbursement Float
This represents the value of the checks the firm has written but which are still being
processed and thus have not been deducted from the firm’s account balance by the bank.

Problem:
Suppose a firm writes on the average checks amounting to P75,000 each day, and it
takes 5 days for these checks to clear and to be deducted from the firm’s bank account. How
much is the difference in amount on the amount reported by the firm?
Solution:
P75,000 x 5 days = P375,000
Collections Float
This represents the amount of checks that have been received but which have not yet
been credited to the firm’s account by the bank.

Problem:
Suppose the firm receives checks in the amount checks in the amount of P100,000 but it
loses 5 days , while they are being deposited and cleared.
Required: Compute for the collection float.
Solution:
P100,000 x 5 days = P500,000
Cash disbursement Float - Collection float = Net Float
P375,000 - 500,000 = 125,000negative

Note: If the float is negative it means that collection float is greater than the disbursement
float. Thus the available bank balance is smaller than the book balance. Thus the firm should
maintain a higher cash balance than it would have in the absence of the float.
The firm must be able to forecast its disbursements and collections accurately in order
to make much heavy use of float. Basically, the size of a firm’s net float is a function of its
ability to speed up collections on checks received and to slow down collections on checks
written. Efficient firms go to great lengths to speed up the processing of incoming checks thus
putting the funds to work faster and they try to stretch their own payments out as long as
possible.

Accelerating Cash Collections

The finance manager should take steps for speedy collections from debtors and for this
purpose, proper internal control should be installed in the firm. Once the credit sales have
been effected, there should be built-in mechanism for timely recovery from the debtors such
as:
1. Prompt billing and periodic statements prepared to show the outstanding bills.
2. Incentives such as trade and cash discounts offered to the customers for
early/prompt payments. These should be well communicated to them.
3. Prompt deposit. Once the checks/drafts are received from customers, no delay
should occur in depositing these receipts with the bank.
4. Direct deposit to firm’s bank account. Customers may also be advised to deposit
their checks or cash directly into the bank account of the firm and furnish details to
the firm,
5. Electronic depository transfer or payment by wire. With the developments taking
place in the computer technology, the present booking system is also being switched
 over to the computer network of banks to offer efficient banking services and cash
management services to their customers. The network will be linked to the different
branches, banks and the transfer of funds will take place very fast that will result to
substantial reduction of float.

Slowing Disbursements
Any action done by the finance officer which slows the disbursement of funds lessens the use
for cash balance.

Strategies
1. Centralized Processing of payables
This allows the finance manager to evaluate the payments coming due for the entire
firm and to schedule the availability of funds to meet these needs on a company-wide basis. It
also results to a more efficient monitoring of payables and float balances. However, care should
be taken so as not to create ill will among suppliers of goods and services or raise the company’s
cost if bills are not paid on time.
2. Zero balance Accounts (ZBA)
These are special disbursement accounts having a zero peso balance on which checks
are written. As checks are presented to a ZBA for payment, funds are automatically transferred
from the master account.
3. Delaying Payment
If one is not going to take advantage of any offered trade discount for early payment,
pay on the last day of the credit period.
4. “Play the Float”
This involves taking advantage of the time it takes for the company’s check to clear the
banking system.
5. Less frequent payroll
Instead of paying the workers on a weekly basis, they may be paid bi-monthly or
monthly basis.

Reducing the Need for Precautionary Balance

The transaction and precautionary motives are the important determinants of the cash
requirement, factors influencing their combined level in the firm must be analyzed.

Techniques Used for Reducing the Need for Precautionary Balances

1. More accurate cash budgeting
An accurate forecast of cash inflows and outflows lessens the need for [precautionary
balances.
2. Lines of Credit
A prearranged loan where the company can withdraw anytime within the period agreed
upon.
 3. Temporary Investments
Investment in highly liquid securities may be maintained instead of holding the
precautionary cash balance.

Problems 1. Accelerating of Cash Receipts

Reanne Company is evaluating a special processing system as a cash receipts acceleration
device. Annually, the firm receives remittances totaling P5 million by check. The firm will record and
process 5,000 checks over the same period. Bank of the Philippine Islands has informed the
management of Reanne Company that it will process checks and associated documents through the
special processing system for a unit cost of P.25 per check. Reanne Company’s financial manager has
projected that cash freed by adoption of the system can be invested in a portfolio of near-cash assets
that will yield an annual before-tax return of 8% . Reanne Company’s financial analysts use a 365-day
year in their procedures.
Required:
1. What reduction in check collection is necessary for Reanne company to be neither better nor
worse off for having adopted the proposed system?
2. How would your solution to be affected if Reanne Company could invest the freed balances only
at an expected annual return of 5.5%?
3. What is the logical explanation for the differences in your answers to 1 and 2.
Solution:
a. Initially, calculate Reanne Company’s average remittance check amount and the daily
opportunity cost of carrying cash.

Average check size = annual check remittances = 5,000,000 = P1,000/check

No. of checks processed 5,000
The daily opportunity cost of carrying cash is = Annual yield before tax return
No of years in a year

= .08/365 = 0.0002192 per day

Days saved in the collection process = Added costs = added benefits

Or
P = (D) (S) (i)
Where: P = Unit cost per check
D = Days saved in the collection process
S = average check size/day
I = daily opportunity cost of carrying cash

Days saved in the collection process

P0.25 = (D) (P1,000) (0.0002191)
0.25 = .2191 D
D = .25/.2191 = 1.141 days
 Analysis:
Reanne Company therefore will experience a financial gain if it implements the special
processing system and by doing so will speed up its collection by more than 0.2191 days.

1. Daily opportunity cost of carrying cash if annual return is 5.5%

= annual yield before tax = 0.055 = 0.0001507 per day
No. of days in a year 365

Days saved in the collection process

P0 .25 = (D) (P1,000) (0.0001507)
0.25 = .1507D
D = .25/.1507 = 1.659 DAYS
Analysis:
For Reanne Company to break-even, should it choose to install the special processing
system, cash collections must be accelerated by 1.659 days.
2. The break-even cash acceleration period of 1.659 days is greater than the reduction in check
collection for adopting the proposed system. This is due to the lower yield available on near-
cash assets of 5.5% annually, versus 8%. Since the alternative rate of return on the freed-up
balances is lower in the second situation, more funds must be invested to cover the cost of
operating the special processing system. The greater cash-acceleration period generates this
increased level of required funds.

Problem 2. Valuing Float Reduction

Raeviene Company expects its gross revenues from sales to be P50,000. The firm’s treasurer
Has projected that its marketable securities portfolio will earn 4.50 percent over the coming budget
year.

Required:
What is the value of one day’s float reduction to the company? Raeviene Company uses a 365-
day year in all of its financial analysis procedures.

Solution:
Value of one day’s float reduction = P50,000,000 x 4.5% = P6,164.38
365
Analysis: the company will earn P6,164.38 per year if it is able to invest its one day sales at 4.5%.