THE MANAGEMENT OF CASH

Why organizations hold cash

The economist John Maynard Keynes identified three reasons for holding cash.
(a) A business needs cash to meet its regular commitments of paying its accounts
payable, its employees' wages, its taxes, its annual dividends to shareholders and so on.
This reason for holding cash is what Keynes called the transactions motive.
(b) There also is a precautionary motive for holding cash. This means that there is a
need to maintain a 'buffer’ of cash for unforeseen contingencies. In the context of a
business, this buffer may be provided by an overdraft facility, which has the advantage
that it will cost nothing until it is actually used.
© A third motive for holding cash – the speculative motive. Some businesses hold
surplus cash as a speculative asset in the hope that interest rates will rise. However,
many businesses would regard large long-term holdings of cash as not prudent.
However, holding cash or near equivalents to cash has a cost – the loss of earnings which
would otherwise have been obtained by using the funds in another way. The financial manager
must try to balance liquidity with profitability.
Cash flow problems
Cash flow problems can arise in various ways.
(a) Making losses:
If a business is continually making losses, it will eventually have cash flow problems. If the
loss is due to a large depreciation charge, the cash flow troubles might only begin when the
business needs to replace non-current assets.
(b) Inflation
In a period of inflation, a business needs ever-increasing amounts of cash just to replace
used-up and worn-out assets. A business can be making a profit in historical cost
accounting terms, but still not be receiving enough cash to buy the replacement assets it
needs.
(c) Growth
When a business is growing, it needs to acquire more non-current assets, and to support
higher amounts of inventories and accounts receivable. These additional assets must be
paid for somehow (or financed by accounts payable).
(d) Seasonal business:
When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain
times of the year, when (i) Cash inflows are low, but (ii) Cash outflows are high, perhaps
because the business is building up its inventories for the next period of high sales.
(e) One-off items of expenditure:
A single non-recurring item of expenditure may create a cash flow problem. Examples
include the repayment of loan capital on maturity of the debt or the purchase of an
exceptionally expensive item, such as a freehold property.

Cash flow forecasts

Cash flow forecasts show the expected receipts and payments during a forecast period and
are a vital management control tool, especially during times of recession.

A cash flow forecast is a detailed forecast of cash inflows and outflows incorporating both
revenue and capital items.
A cash flow forecast is thus a statement in which estimated future cash receipts and
payments are tabulated in such a way as to show the forecast cash balance of a business at
defined intervals.
The usefulness of cash flow forecasts:
The cash flow forecast is one of the most important planning tools that an organization can use.
It shows the cash effect of all plans made within the flow forecasting process and hence its
preparation can lead to a modification of flow forecasts if it shows that there are insufficient
cash resources to finance the planned operations. It can also give management an indication of
potential problems that could arise and allows them the opportunity to take action to avoid
such problems. A cash flow forecast can show four positions. Management will need to take
appropriate action depending on the potential position.

Cash position Appropriate management action

Short-term surplus -Pay accounts payable early to obtain discount
- Attempt to increase sales by increasing accounts receivable and
inventories
- Make short-term investments
Short-term deficit - Increase accounts payable by delaying payments to suppliers
- Reduce accounts receivable by improving collection of overdue
payments
- Arrange a bank overdraft facility, or increase the limit on an
existing facility
Long-term surplus - Make long-term investments
- Expand
 - Diversify
- Replace/update non-current assets.
- Distribute the surplus to shareholders
Long-term deficit - Raise long-term finance (such as via issue of share capital)
- Consider shutdown/disinvestment opportunities
A cash flow forecast question could ask you to prepare the cash flow forecast and then
recommend appropriate action for management.
Methods of easing cash shortages
Cash shortages can be eased by: postponing capital expenditure, selling assets, taking longer to
pay accounts payable and pressing accounts receivable for earlier payment. The steps that are
usually taken by a company when a need for cash arises, and when it cannot obtain resources
from any other source such as a loan or an increased overdraft, are as follows.
a) Postponing capital expenditure:
Some new non-current assets might be needed for the development and growth of the
business, but some capital expenditures might be postponable without serious
consequences. If a company's policy is to replace company cars every two years, but the
company is facing a cash shortage, it might decide to replace cars every three years.
(b) Accelerating cash inflows which would otherwise be expected in a later period
One way would be to press accounts receivable for earlier payment. Often, this policy
will result in a loss of goodwill and problems with customers. It might be possible to
encourage credit customers to pay more quickly by offering discounts for earlier
payment.
(c) Reversing past investment decisions by selling assets previously acquired:
Some assets are less crucial to a business than others. If cash flow problems are severe, the
option of selling investments or property might have to be considered. Sale and leaseback of
property could also be considered.
(d) Negotiating a reduction in cash outflows, to postpone or reduce payments:
There are several ways in which this could be done.
(i) Longer credit might be taken from suppliers. Such an extension of credit would have
to be negotiated carefully: there would be a risk of having further supplies refused.
(ii) Loan repayments could be rescheduled by agreement with a bank.
(iii) A deferral of the payment of company tax might be agreed with the taxation
authorities. They will however charge interest on the outstanding amount of tax.
 (iv) Dividend payments could be reduced. Dividend payments are discretionary cash
outflows, although a company's directors might be constrained by shareholders'
expectations, so that they feel obliged to pay dividends even when there is a cash
shortage.
Deviations from expected cash flows
Cash flow forecasts, whether prepared on an annual, monthly, weekly or even a daily basis,
can only be estimates of cash flows. Even the best estimates will not be exactly correct, so
deviations from the cash flow forecast are inevitable.

Treasury management
A large organization will have a treasury department to manage liquidity, short-term
investment, borrowings, foreign exchange risk and other, specialized, areas such as forward
contracts and futures.
Treasury management can be defined as: 'The corporate handing of all financial matters, the
generation of external and internal funds for business, the management of currencies and
cash flows, and the complex strategies, policies and procedures of corporate finance.'
(Association of Corporate Treasurers)
KEY FUNCTIONS
(a) Management of Liquidity
(b) Management of funding
(c) Management of risk
(d) Advising on corporate finance issues.
ADVANTAGES OF Centralised treasury department.
a) Centralised Liquidity Management
(i) Avoids having a mix of cash surpluses and overdrafts in different localised
bank accounts.
(ii) Facilitates bulk cash flows, so that lower bank charges can be negotiated.
(b) Larger volumes of cash are available to invest, giving better short-term investment
opportunities (for example money markets, high-interest accounts and CDs).
(c) Any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings,
and perhaps on the eurocurrency or eurobond markets.
(d) Foreign exchange risk management is likely to be improved in a group of companies.
(e) A specialist treasury department can employ experts with knowledge of dealing in forward
contracts, futures, options, eurocurrency markets, swaps and so on. Localised departments
could not have such expertise.
(f) The centralised pool of funds required for precautionary purposes will be smaller than the
sum of separate precautionary balances which would need to be held under decentralised
treasury arrangements.
(g) Through having a separate profit centre, attention will be focused on the contribution to
group profit performance that can be achieved by good cash, funding, investment and foreign
currency management.
Possible advantages of decentralised cash management are as follows.
(a) Sources of finance can be diversified and can match local assets.
(b) Greater autonomy can be given to subsidiaries and divisions because of the closer
relationships they will have with the decentralised cash management function.
(c) A decentralised treasury function may be more responsive to the needs of individual
operating units.
(d) Since cash balances will not be aggregated at group level, there will be more limited
opportunities to invest such balances on a short-term basis.
Cash Management Models
Optimal cash holding levels can be calculated from formal models, such as the Baumol model
and the Miller-Orr model.
a) The Baumol model
The Baumol model is based on the idea that deciding on optimum cash balances is like deciding
on optimum inventory levels. It assumes that cash is steadily consumed over time and a
business holds a stock of marketable securities that can be sold when cash is needed. The cost
of holding cash is the opportunity cost, ie the interest foregone from not investing the cash. The
cost of placing an order is the administration cost incurred when selling the securities. The
Baumol model uses an equation of the same form as the EOQ formula for inventory
management which we looked at earlier.
Q= 2CS/ i
Where S = the amount of cash to be used in each time period
C = the cost per sale of securities
i = the interest cost of holding cash or near cash equivalents
 Q = the total amount to be raised to provide for S
Example: Baumol approach to cash management
Finder Co faces a fixed cost of $4,000 to obtain new funds. There is a requirement for $24,000
of cash over each period of one year for the foreseeable future. The interest cost of new funds
is 12% per annum; the interest rate earned on short-term securities is 9% per annum. How
much finance should Finder raise at a time?

b) The Miller-Orr model

In an attempt to produce a more realistic approach to cash management, various models more
complicated than the inventory approach have been developed. One of these, the Miller-Orr
model, manages to achieve a reasonable degree of realism while not being too elaborate. We
can begin looking at the Miller-Orr model by asking what will happen if there is no attempt to
manage cash balances. Clearly, the cash balance is likely to 'meander' upwards or downwards.
The Miller-Orr model imposes limits to this meandering. If the cash balance reaches an upper
limit (point A) the firm buys sufficient securities to return the cash balance to a normal level
(called the 'return point'). When the cash balance reaches a lower limit (point B), the firm sells
securities to bring the balance back to the return point. Time Cash balance 0 Upper limit
The usefulness of the Miller-Orr model is limited by the assumptions on which it is based. In
practice, cash inflows and outflows are unlikely to be entirely unpredictable as the model
assumes: for example, for a retailer, seasonal factors are likely to affect cash inflows. However,
the Miller-Orr model may save management time which might otherwise be spent in
responding to those cash inflows and outflows which cannot be predicted.
INVESTING SURPLUS CASH
Temporary surpluses of cash can be invested in a variety of financial instruments. Longer-term
surpluses should be returned to shareholders if there is a lack of investment opportunities.
Companies and other organisations sometimes have a surplus of cash and become 'cash rich'.
A cash surplus is likely to be temporary, but while it exists the company should invest or deposit
the cash bearing the following considerations in mind:
(a) Liquidity – money should be available to take advantage of favourable short-term
interest rates on bank deposits, or to grasp a strategic opportunity, for example paying
cash to take over another company.
(b) Profitability – the company should seek to obtain a good return for the risk incurred
FAST FORWARD Exam focus point Part C Working capital management
(c) Safety – the company should avoid the risk of a capital loss.
Other factors that organisations need to consider include:
(a) Whether to invest at fixed or floating rates. Floating rate investments are likely to be
chosen if interest rates are expected to rise.
(b) Term to maturity. The terms chosen will be affected by the business's desire for
liquidity and expectations about future rates of interest; if there are major uncertainties
about future interest rate levels it will be better to choose short-term investments.
There may also be penalties for early liquidation.
(c) How easy it will be to realise the investment.
(d) Whether a minimum amount has to be invested in certain investments.
(e) Whether to invest on international markets.
Surplus cash may be returned to shareholders by:
(a) Increasing the usual level of the annual dividends which are paid
(b) Making a one-off special dividend payment (For example, National Power plc and BT
plc have made such payments in recent years.)
(c) Using the money to buy back its own shares from some of its shareholders. This will
reduce the total number of shares in issue, and should therefore raise the level of
earnings per share.
If surplus cash is to be invested on a regular basis, organisations should have investment
guidelines in place covering the following issues:
(a) Surplus funds can only be invested in specified types of investment (eg no equity
shares).
(b) All investments must be convertible into cash within a set number of days.
(c) Investments should be ranked: surplus funds to be invested in higher risk instruments
only when a sufficiency has been invested in lower risk items (so that there is always a
cushion of safety).
(d) If a firm invests in certain financial instruments, a credit rating should be obtained.
Credit rating agencies, discussed earlier, issue gradings according to risk.
Short-term investments
Temporary cash surpluses are likely to be:
(a) Deposited with a bank or similar financial institution.
 (b) Invested in short-term debt instruments, such as Treasury bills or CDs. (Debt
instruments are debt securities which can be traded.)
(c) Invested in longer term debt instruments such as government bonds, which can be
sold when the company eventually needs the cash.
(d) Invested in shares of listed companies, which can be sold on the stock market when
the company eventually needs the cash. Investing in equities is fairly high risk, since
share prices can fall substantially, resulting in large losses on investment.
Short-term deposits:
Cash can of course be put into a bank deposit to earn interest. The rate of interest obtainable
depends on the size of the deposit, and varies from bank to bank.
Short-term debt instruments:
There are a number of short-term debt instruments which an investor can re-sell before the
debt matures and is repaid. These debt instruments include certificates of deposit (CDs) and
Treasury bills. These have already been described in the context of money market instruments.
Certificates of deposit (CDs)
A CD is a security that is issued by a bank, acknowledging that a certain amount of money has
been deposited with it for a certain period of time (usually, a short term). The CD is issued to
the depositor, and attracts a stated amount of interest. CDs are negotiable and traded on the
CD market (a money market), so if a CD holder wishes to obtain immediate cash, he can sell the
CD on the market at any time. This second-hand market in CDs makes them attractive, flexible
investments for organisations with excess cash. A company with a temporary cash surplus may
therefore buy a CD as an investment.
Treasury bills
Treasury bills are issued weekly by the government to finance short-term cash deficiencies in
the government's expenditure programme. They are IOUs issued by the government, giving a
promise to pay a certain amount to their holder on maturity. Treasury bills have a term of 91
days to maturity, after which the holder is paid the full value of the bill. The market for Treasury
bills is very liquid, and bills can be bought or sold at any time.

Working capital investment policy

Organisations have to decide what are the most important risks relating to working capital,
and therefore whether to adopt a conservative, aggressive or moderate approach to
investment in working capital.
A conservative approach
A conservative working capital investment policy aims to reduce the risk of system breakdown
by holding high levels of working capital.
Customers are allowed generous payment terms to stimulate demand, finished goods
inventories are high to ensure availability for customers, and raw materials and work in
progress are high to minimise the risk of running out of inventory and consequent downtime in
the manufacturing process. Suppliers are paid promptly to ensure their goodwill, again to
minimise the chance of stock-outs.
However, the cumulative effect on these policies can be that the firm carries a high burden of
unproductive assets, resulting in a financing cost that can destroy profitability. A period of
rapid expansion may also cause severe cash flow problems as working capital requirements
outstrip available finance. Further problems may arise from inventory obsolescence and lack of
flexibility to customer demands.
An aggressive approach
An aggressive working capital investment policy aims to reduce this financing cost and
increase profitability by cutting inventories, speeding up collections from customers, and
delaying payments to suppliers.
The potential disadvantage of this policy is an increase in the chances of system breakdown
through running out of inventory or loss of goodwill with customers and suppliers. However,
modern manufacturing techniques encourage inventory and work in progress reductions
through just–in–time policies, flexible production facilities and improved quality management.
Improved customer satisfaction through quality and effective response to customer demand
can also mean that credit periods are shortened.
A moderate approach:
A moderate working capital investment policy is a middle way between the aggressive and
conservative approaches. These characteristics are useful for comparing and analysing the
different ways individual organisations deal with working capital and the trade off between risk
and return.
Permanent and fluctuating current assets
In order to understand working capital financing decisions, assets can be divided into three
different types.
(a) Non-current (fixed) assets are long-term assets from which an organisation expects
to d
(b) erive benefit over a number of periods. For example, buildings or machinery.
 (b) Permanent current assets are the amount required to meet long-term minimum
needs and sustain normal trading activity. For example, inventory and the average level
of accounts receivable.
(c) Fluctuating current assets are the current assets which vary according to normal
business activity, for example due to seasonal variations.
Fluctuating current assets together with permanent current assets form part of the working
capital of the business, which may be financed by either long-term funding (including equity
capital) or by current liabilities (short-term funding).
Other factors
The trend of overall working capital management will be complicated by the following factors:
(a) Industry norms:
These are of particular importance for the management of receivables. It will be difficult to
offer a much shorter credit period than competitors.
(b) Products:
The production process, and hence the amount of work in progress is obviously much greater
for some products and in some industries.
(c) Management issues:
How working capital is managed may have a significant impact upon the actual length of the
working capital cycle whatever the overall strategy might be. Factors to consider include:
(i) The size of the organisation
(ii) The degree of centralisation (which may allow a more aggressive approach to be
adopted, depending though on how efficient the centralised departments actually
are)
(iii) Management attitudes to risk
(iv) Previous funding decisions

End of paper