What is cash management?
Cash management is a broad term that covers a number of functions that help individuals and businesses process receipts and payments in an organized and efficient manner. Administering cash assets today often makes use of a number of automated support services offered by banks and other financial institutions. The range of cash management services range from simple checkbook balancing to investing cash in bonds and other types of securities to automated software that allows easy cash collection.
Motives for holding cash (a) Transaction Motive : This motive refers to the holding of cash in order to meet the day-to-day expenses of the business. These transactions including purchase of raw material, packing materials, wages, operating expenses, taxes, dividend etc. (1) since the timing of cash inflows and the cash outflows d iffer significantly, a minimum cash balance is required. At the same time, there is regular inflow of cash from sales proceeds, income from investments etc. But inflows and outflows-of cash do not perfectly coincide. (2) Sometimes the firm has surplus cash in certain periods, which the firm invests in easily marketable securities. These are sold and cash realized when need for payment arises in business. (3) Some firms keep cash on hand to meet some anticipated payments. It may invest such surplus cash in such a way that it will mature when anticipated payment is to be made. (4) The company is also required to keep some cash on hand to make regular annual payments, e.g. once in a year, cash is needed to pay dividend. Similarly, advance tax is payable every t hree months for which a firm is required to hold some cash. Here again it can be invested in short term marketable securities. (b) Precautionary Motive : This motive for holding cash refers to maintaining a cash balance to meet unexpected contingencies, whi ch may arise as a result of
-Uncontrollable circumstances, such as floods, strikes, earthquakes etc. - Sharp increase in the cost of materials, labor etc. - Unexpected delay in collection of accounts receivables. Thus precautionary balance is required to meet unforeseen contingencies. If the event for which cash balance is kept is more unpredictable, the larger would be the cash needed. If there has been a careful planning, less cash would be required.
. (2) The degree of deviation between expected and actual net cash flows. if any. It is believed that business firms should not indulge in speculative transactions. in the sense that money can be recovered from insurance company and so less cash may be maintained. as it involves risks that can put firm in trouble. (3) The maturity structure of the firm¶s liabilities. it requires caution. clients (firms) are required to maintain a minimum cash balance at the bank which cannot be utilized by them for transaction purpose. It is for the finance manager to determine the cash to be held looking to the circumstances available.Speculating on interest rate movements etc. against a nominal fee or commission. However. e. It helps to take advantage of
. Such transactions made at times will raise the profitability of business.
(d) Compensating Motive : Banks provide different types of services to t he firms.If the firm has a good prestige in the market. so that it can earn some return.Purchasing raw materials at reduced prices by availing the benefits of cash discount.
(c) Speculative Motive : It refers to the desire of a firm to keep cash to take advantage of profitable opportunities. which are outside the normal course of business.g. Insurance against some of the risks ma \ also come to the help. which are two most important motives. Conditions would differ from industry to industry and also from firm to firm. it will require less cash to be maintained for contingencies. Generally. The holding of cash for speculative motive by a business firm is debatable. they provide to customers. so that it earns some return. . Hence. Such balances are called compensating balance. foresight and skill. the best way is not to hold cash for speculative motive. should also be invested in sound securities. The bank can use the same for generating returns. transfer of funds etc. the banks require the clients to always keep a bank balance sufficient to earn a return equal to the cost of services. clearance of cheque. But no cut and dried formula can be suggested. Generally such cash is held in the form of marketable securities. Another viewpoint is that surplus cash. it can borrow from banks or from other sources at a short notice. To get compensated for free services.
The amount of cash to be held for the first two motives. the following factors must be taken into account: (1) The expected cash inflows and outflows based on cash budget.
Following are main advantages of adequate cash 1. They are as follows:
(a) Cost of raising cash-Cost incurred (brokerage etc. (5) The philosophy of management regarding liquidity and risk of insolvency. Objectives of cash management
1) To make Payment According to Payment Schedule:. 2. Therefore optimum level of cash should be maintain.It helps firm to maintain good relation¶s with suppliers. (6) The efficient planning and control of cash.) in selling of marketable securities or interest expense incurred for borrowing cash.
(2) To minimise Cash Balance:-
The second objective of cash management is to minimise cash balance. salary. when cash available with firm is less. Excessive amount of cash balance helps in quicker payments. Contrarily. but excessive cash may remain unused & reduces profitability of business.
. taxes etc. duration and frequency of shortfall and here the shortage is covered. Hence.Contingencies can be met easily. (ii) Cash Out cost: Every shortfall in cash whether expected or unexpected is associated with some cost. firm is una ble to pay its liabilities in time.
Factors determining cash needs: (i) Synchronization of Cash flow: The need for maintaining cash balance arises from a mis-match of cash receipts and cash payments.To prevent firm from being insolvent. depending upon the severity.(4) The firm¶s ability to borrow at short notice in the event of any emergency.The relation of firm with bank does not deteriorat 3. Cash budget is an appropriate technique to determin e when the firm will have excess cash or a shortage of cash. the first factor taken into account is the non-synchronization of cash receipts and cash payments.Firm needs cash to meet its routine expenses including wages. 4. Expenses incurred as a result of shortfall are called short costs.
(iv) Cost of Cash Management: These are administrative cost incurred for management of cash. It reveals the expected shortages of cash. salary of the concerned staff . It includes cost.e. This can be reduced through improved forecasting of cash payments and through abili ty to borrow through bank overdraft. capital expenditures. This loss of interest is the idle cash carrying cost. the firm is incurring an opportunity cost in terms of loss of interest had this money been utilized somewhere else to earn some return.(b) Loss of benefit of purchasing on µcash-discount¶ terms. Cash budget is a useful tool in the cash management of organizations as it reveals potential cash shortages as well as potential periods of excess cash.etc.g. Importance of Cash Budget
Cash is the nucleus or life blood in the working capital management. handling cost of securities etc.a bank overdraft or loan may be arranged. It brings equilibrium between available cash and the cash demanding activities ± operations. CASH BUDGETING
Meaning-Cash budget is a schedule to record cash inflows and outflows over a period with a view to locating the timing and magnitude of cash surplus and shortage.
Advantages of Cash Budget
It ensures that sufficient cash is available when required.
. so that action may be taken in time.
Definition-Cash budget is an estimate of cash receipts and disbursement for a future period of time. (c) Loss of reputation for not being able to make payment in due time.. customer¶s default etc. (v) Uncertainty in Cash flows : The cost incurred is keeping idle cash to take care of irregular cash collections.
(iii) Idle-cash carrying cost: If the cash remains idle in the firm.
payments to creditors are estimated on the basis of purchase budget. Of course. e. (1) Receipts and Payments Method-The estimates under this method may be divided into weekly. for wages and factory overhead. the credit period allowed by suppliers. From the past experience. 3. the proportion of cash sales can be determined. capital expendit ure like purchase of assets. must be considered. In estimating payments to creditors. overhead expenses.
Methods of Cash Budget:
There are three methods usually used in preparation of cash budget:
1. Due to its flexibility.g. Once the total sales are estimated. The method is of particular importance in business where sale is unstable or seasonal or which suffers from shortage of liquid resources. It reveals the availability of cash so that advantage may be taken of cash discounts. payments for wages. Th ere is no time-lag between sales and receipts in respect of cash sales. etc. Receipts and payments Method. The first step in preparing a cash budget under this method is to estimate the sales. as sale is the most important source of cash receipts. Any changes likely to occur in the future budget period are taken into account. Overheads can also be based on overheads budget. Adjusted Profit and Loss Method. dividends. fortnightly or monthly basis. the estimates on various accounts are based on various operating budgets. It shows whether capital expenditure projects can be financed internally. the basis will be production budget etc. this method is used in planning cash at various time periods and thus helps in controlling cash disbursements.or arrangement has to be made borrowings. Projected Balance Sheet Method. The payment on account of capital expenditure can be estimated on the basis of Capital Expenditure budget. repayment of loans. 2. non-operating incomes like interest and dividend as well as capital transactions like sale of assets and issue of shares and debentures. it is easy to put down the figures of cash sales. adjustments like depreciation and accruals should not be taken into
. (b) Estimating Cash Payments: Cash payments generally consist of payment to creditors on account of credit purchases. cash discount etc. (a) Estimating Cash Receipts: The sources of cash receipts and a business are generally sales.
it is easy to estimate the total amount of dividend payable.
3) Projected Balance Sheet method -Based on the last years balance sheet we calculate the budget required. The minimum cash to hold is the greater of (1) compensating balances (a deposit held by a bank to compensate it for providing services) or (2) precautionary balances (money held in c ash for an emergency) plus transaction balances (money to cover uncleared checks)
. (ii) Changes in working capital which results in inflow of cash balances such as increase in closing stock. stock fluctuations. Optimal balance here means a position when the cash balance amount is on the most ideal proportion so that the company has the ability to invest the excess cash for a return [profit] and at the same time have sufficient liquidity for future needs. payment of dividend. debtors and decrease in sundry creditors and other liabilities. minimizing the sum of fixed cost of transactions and the opportunity cost of holding cash balance. prepaid expenses etc. the assumption needs adjustments. such a situation will never exist in actual practice. or appropriations of profit. purchase capital assets. redemption of preference shares and debentures. Payment on account of dividend may be a difficult problem. deferred revenue expenditure.
2) Adjusted Profit & Loss method -Under this method. investment etc. However. writing off of intangible assets. capital transactions. But in case of companies which adopt stable dividend policy. Items included are: (i) All non-cash items shown in the debit side of profit and loss account should be added to the budgeted profit because these items do not involve any cash outflows-depreciation. Thus if we assume that there are no credit transactions.
Cash Management Models:
The main objective of cash management is an optimal cash balance. the balance of profit as shown by the profit and loss account should b equal to the cash balance in the case book. closing cash balance can be known by adding profits for the period to the opening cash balance because the theory is based on the elementary assumption that profits of a business are equal to cash.account. provisions. accruals. The key ingredient is that the cash balance should neither be excessive nor deficient.
Determining Optimal Cash Balance under Conditions of Certainty [William Baumol¶s Cash Model]:
William Baumol developed a cash model to determine the optimum amount of transaction cash under conditions of certainty. Total conversion cost per period = T*b/C where b =cost per conversion T = total cash needs for the time period involved C = Value of marketable securities sold at each conversion 2) Opportunity cost ± This cost is derived from the lost/forfeited interest rate (i) that could have been earned on the investment of cash balances. The purpose of this model is to determine the minimum cost amount of cash that a financial manager can obtain by converting securities into cash.The company needs sufficient cash to satisfy daily requirements. Determining the optimal cash balance is one among the most a crucial task in cash management area. The objective is to minimize the sum of the fixed costs of transactions and the opportunity cost of holding cash balances. considering the cost of conversion and the counter balancing cost of keeping the idle cash balances which otherwise could have been invested i n marketable securities. The total opportunity cost is the interest rate times the average cash balance kept by firm. How to determine the optimal cash balance? William Baumol and Miller-Orr offer cash models to determine the optimal cash balance that you can use. The total costs associated with cash management according to this model are 1) Cost of converting marketable securities into cash ± These are incurred each time marketable securities are converted into cash. i (C/2) where i = interest rate that could have been earned C/2 = Average cash balance The total cost is expressed as: b [T/C] + i [C/2]
as the opportunity interest rate increases. t e cash withdrawal which costs the least The reason is that a firm should not keep the total beginning cash balance during the entire period as it is not needed at the beginning of the period. Symbolically the optimal conversion amount (C is C = sqrt (2bT / i With the increase in the cost per transaction and total funds required. as the total cash needs for transaction rises because of expansion or diversification. termi i Optimal ash Balance Under Conditions of Uncertainty [Miller-Orr¶s Cash Model
. the optimal withdrawal increases less than proportionately. it will decrease. Secondly.Opti
To mi imi t cost t model attempts to determi e t e optimal conversion amount t at is.
The model in terms of above equation has important implications. with an increase in the opportunity cost. First. the optimum cash balance will increase. The model clearly and concisely demonstrate the economies of scale and the counteracting nature of the conversion and opportunity costs which are major considerations in ant financial manager¶s cash management strategy. This is the result of economy of scale in cash management. However. the optimal cash withdrawal decreases.
the MO model assumes that cash balances randomly fluctuate be tween upper bound (h) and lower bound (O). the payment from customers should b e converted into cash without any delay. When the cash balances hit the upper bound.
Speedy Cash Collections
In managing cash efficiently. Secondly. the optimal cash balance z can be expressed as z = Sqrt (3*b*r 2/ 4 * i) where r2 = the variance of daily chan ges in cash balances
Cash Management Techniques/Processes
There are some specific techniques and processes for speedy collection of receivables from customers and slowing disbursements. as in Baumol model. In first place. the cash inflow process can be accelerated through systematic planning and refined techniques.The objective of cash management according to Miller -Orr (MO) is to determine the optimum cash balance level which minimizes the cost of cash management. C = b * E (N) + i * E (M) t where b = the fixed cost per conversion E (M) = the expected average daily cash balance E (N) = the expected no of conversions t = no of days in the period i = the lost opportunity costs C = total cash management costs The MO model is an attempt to make the Baumol model more realistic regards to pattern of cash flows. Symbolically. when the cash balances hit zero. the customers should be encouraged to pay as quickly as possible. According to MO model. the firm has too much cash and should buy enough marketable securities to bring cash balances back to the optimal bound (z). As against the assumption of uniform and certain levels of cash balances in the Baumol model.
. There are two broad approaches to do this. the financi al manager must return them to the optimum bound z by selling/converting securities into cash.
that is. The principal methods of establishing a decentralised collection network are (a) concentration banking and (b) lock-box system. the time taken by the bank in collecting the payment from the customer¶s bank. the collection can be expedited by prompt encashment of the cheque. Within this time interval three steps are involved.
. the customers would be eager to make payment early. lethargy and the bank float are collectively referred to as deposit float. The collection of accounts receivables can be considerably accelerated. We discuss below some of the important processes that ensure decentralised collection so as to reduce (a) the amount of time that elapses between the mailing of the payment by the custome r and (b) the point the funds become available to the firm for use. The postal float.time taken in processing the cheques within the firm before they are deposited in the banks.Prompt Payment by Customers
One way to ensure prompt payment by customers is prompt billing. The avail of t he facility. the time taken by th e post offices to transfer the cheque from the customers to the firm. technique to encourage prompt payment by customers is the practice of offering cash discounts. as a technique to speed up collection of accounts receivables. processing and collection time.
Early Conversion of Payments into Cash
Once the customer makes the payment by writing a cheque in favour of the firm. This is possible if a firm adopts a policy of decentralised collections. is done to re duce the time lag between posting of the cheque by the customer and the realisation of money by the firm. The use of mechanical devices for billing along with the enclosure of a self-addressed return envelope will speed up payment by customers. (a). and more important. by reducing transit. An important cash management technique is reduction in deposit float. This delay or lag is referred to as postal float. Another. There is a lag between the time a cheque is prepared and mailed by the customer and the time the funds are included in the cash reservoir of the firm. The term deposit float is defined as the sum of cheques written by customers that are not yet usable by the firm.collection t ime within the banks. that is. This is called bank float. (b). termed as lethargy and (c). The early conversion of payment into cash.transit or mailing time. What the customer has to pay and the period of payment should be notified accurately and in advance.
apart from effecting economy in mailing and clearance times. The local banks of the firm. (a) avoidance of early payments. slow disbursement represents a source of funds requiring no interest payments. the operating cash requirement can be reduced by slow disbursement of account payable. the cheques for the certain geographical areas are collected a specified local collection centre. Under this arrangement. loan payments. select some of the strategically located branches as collection centres for receiving payment from customers. if any. that is.
Investment of Surplus Funds
Companies often have surplus funds for short periods of time before they are required for capital expenditures. Instead if all the payments being collected at the head office of the firm. (c) floats and (d) accruals. the customers are required to send their payments (cheques) to the collection centre covering the area i n which they live and these are deposited in the local account of the concerned collection centre. large firms which have a large number of branches at different places.In this system of decentralised collec tion of accounts receivable. The lock-box system takes care of this kind of problem. at the respective places. after meeting local expenses. But with this system of collection of accounts receivable. Instead of allowing these surplus funds to accumulate in current account where they
Apart from speedy collection of accounts receivables. namely.
The concentration banking arrangement is instrumental in reducing the time involved in mailing and coll ection. the authorised banks pick up the cheques several times a day and deposit them in the firm¶s accounts. some time elapses before a cheque is deposited by the local collection centre in its account. There are several techniques to delay payment of accounts payable. (b) centralised disbursement. are authorised to open the box and pi ck up the remittances (cheques) received from the customers. The customers are required to remit payments to the post office lock -box. In fact. Thus the lock-box system is like concentration banking in that the collection is decentralised and is done at the branch level. processing for purpose of internal accounting is involved. or some other purpose.
It essentially represents surplus funds with the firm which has been invested in short term instruments to generate income.
CRITERIA FOR EVALUATING INVESTMENT INSTRUMENTS
Safety. It is meant to augment the cash resources of the company to meet unanticipated operational needs. mutual funds. Ready Cash Segment It represents a reserve for company¶s each account. liquidity. Investment in this segment must necessarily be highly liquid in nature. companies invest them in a variety of short -term instruments like term deposits with banks.
Investment Portfolio: Three Segments 1. and so on. investment in this segment must be matched in size and maturity to known future outflows. Controllable Cash Segment It represents that part of the investment portfolio which is meant to meet the needs of knowable outflows like taxes. and so on. thanks to higher corporate liquidity and wider range of investment options. companies invest them in a variety of short term instruments like term deposits with banks. 2. This has become more so in recent years. Free Cash Segment It represents that part of investment portfolio which is meant neither to augment unforeseen current cash needs nor to meet known future outflows. Managing the investment of surplus funds is a very important responsibility of the financial manager. or some other purpose instead of allowing these surplus funds to acccumulate in current acc ount where they earn no interest. loan repaymnet. Ideally. and repayments of borrowings. interest payments. without an excessive concern for liquidity or ma turity.
INVESTMENT OF SURPLUS FUNDS
Companies often have surplus funds for short periods of time before they are required for capital expenditure. dividend. yield and maturity are the most important criteria for evaluating various investment instruments.
. money market. 3. money market mutual funds.earn no interest.
Maturity Maturity refers to the life of the instrument.
. For a traded instrument . others (like certi ficates of deposit) can have tailor-made maturity. For a non-traded instrument . A high degree of safety is essential for an instrument to b considered for inclusion in the short term investment portfolio of the firm. liquidity is high if the penalty for premature liquidation is negligible. Treasury bills may be regarded as the safest of all the instruments as they represent the obligati ons of the government . Liquidity The liquidity of an instrument refers to the ability of the investor to convert it into cash on short notice without incurring a loss.taking into account ht tax rate applicable to the returns earned by the investment instrument. An instrument may be quite safe if. 3. dividend and capital appreciation. it is held till maturity. the greater the yield. safety refers to the probability of getting back the amount invested. but it may not be possible to sell it prematurely without suffering a loss. Generally.The safety of the other instruments depends on the type of the instruments and the issuer.1. Safety Perhaps the most important criterion.but they are sold at a discount and redeemed at face value. the longer the maturity.
4. Yield The yield of an instrument is the return earned from it by way of interest. While some instruments (like Treasury Bills) have fixed original maturities. some instrument like Treasury Bills and commercial papers do not pay interest . Yield has to be measured in post -tax terms . 2.a large and active secondary market ensures liquidity.
CD¶s are fairly liquid. It may be in a registered form or a bearer form.
2. 2. CD¶s are a popular form of short term investment for companies for the following reasons: 1.banks are normally willing to tailor the denominations and maturities to suit the needs of the investors. the holder of the cd gets the principal amount along with the interest thereon.it is sold at a discount and redeemed at par. cds carry an explicit rate of interest .CD¶s generally offer a higher rate of interest than treasury bills or term deposits. commercial paper usually has a maturity period of 90 days to 180 days . commercial paper does not presently have a well developed secondary market in india.the funds deposited earn a fixed rate of interest .
. 4. 3.CD¶s are generally risk free. The main attraction of commercial paper is that it offers an interest rate that is typically higher than that offered by treasury bills or certificates of deposit.INVESTMENT OPTION
1. commercial paper is either directly placed with investors or sold through dealers. Unlike treasury bills . however its disadvantage is that it does not have an active secondary market .hence it makes sense for firms that plan to hold till maturity. hence the implicit rate is a function of the size of discount and the period of maturity. Certificates of Deposits: A certificate of deposit represent a negotiable receipt of funds deposited in a bank for a fixed period.on maturity. The latter is more popular as it can be transacted more readily in the secondary market. Commercial Papers Commercial paper represents short term unsecured promissory notes issued by firms that are generally con sidered to be financially strong.
such deposits are usually for three types: 1. though not the optional contribution. a call deposit is withdraw able by the lender on giving a day¶s notice in practice. Call Deposits: in theory . 2. to profitability without impairing the liquidity of the firm. Six-Month Deposits: normally lending companies do not extend deposits beyond this time frame such deposits are usually made with first class borrowers. Ride the Yield Curve:
. 2. normally for a period of upto six months is referred to as an inter-corporate deposit. however the lender has to wait for at least three days. such a strategy makes some contribution. Do Nothing: The financial manager simply allows surplus liquidity to accumulate in the current account. Make Ad-Hoc Investments: The financial manager makes investments in somewhat ad hoc manner.3. this strategy enhances liquidity at d expense of profit that could be earned by investing surplus funds. these depends are taken by borrowers to tide over a short term cash inadequacy. it is followed by the firms which cannot devote enough time and resources to management of securities.
STRATEGIES FOR MANAGING SURPLUS FUNDS
The financial managers can consider a series of seven strategies for handling the excess cash balance with the firm. Inter ±Corporate Deposits A deposit made by one company with another.
3. Three Month Deposits: more popular in practice. 1. 3.
Do not put more than a certain percentage of liquid funds in a particular security or instruments.the model prescribes that a certain amount should be invested in marketable securities.
6. compared to shorter term securities. Define the efficient frontier:
.This is a strategy to increase the yield from a portfolio of marketable securities by betting on interest rate charges. Develop Guidelines: A firm may develop a set a guidelines which may reflect the view of management towards risk and return. Manage with a portfolio perspective: According to the portfolio theory there are two key steps in portfolio selection a. Examples of such guidelines are: 1. if the financial manager beli eves that the interest rate will increase in the near future . If the financial manager expects that the interest rate will fall in the near future he will buy long term securities as there appreciate more. using a set of guidelines which supposedly reflect conventional wisdom often provides a µ satisfying¶ solution and not an µoptimal¶ solution. Utilise Control Limits: There are some models of cash management which assumes that ca sh inflows and outflows occur randomly over time. 4. the model says that a certain amount of marketable securities sho uld be liquidated to augment the cash resources of the firm. 3. Do not speculate on interest rate charges 2. When the cash balance touches the upper limit . Minimize transaction cost. Based on this premise. these models define the upper and lower control limits.he would sell long term securities. On the other hand. 5. This strategy hinges on d assumption that the financial manager has superior interest rate forecasting abilities. Yet they are found useful by firms which want liquidity management to be orderly and systematic. By the same token when the cash balance hits the lower limit.
7. Follow a Mechanical Procedure: The financial manager may shift funds between a cash account and marketable securities using a mechanical procedure. mechanical procedures are of rather limited use.the same standard deviation and a higher expected return or iii. b.same expected return and a lower standard variation or ii. It appears that. Select the optimal portfolio: The optimal portfolio is that point on the efficient frontier which enables the investor to achieve the highest attainable level of utility. The success of such a strategy depends on how well the behavior on the firm¶s cash flows conforms with the assumptions of the model.
.The efficient frontier represents a collection of all efficient portfolios. Some models have been developed that provides rules for such mechanic al procedures.a higher expected return and a lower standard deviation. in practice. it is found at the point of tangency between the efficient front ier and a utility indifference curve. A portfolio is efficient if there is no alternative with i.