Cash Management

Motives for holding cash

Transaction motive
Precautionary motive Speculative motive Compensating motive

Holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business is known as

transaction motive.

Cash balances held in reserve for random and unforeseen fluctuations in cash flows are called as

precautionary motive. EXAMPLES 1. Floods, strikes and failure of important customers

2. Bills may be presented for settlement

earlier than expected 3. Unexpected slow down in collection of accounts receivable 4. Cancellation of some order for goods as the customer is not satisfied 5. Sharp increase in cost of raw materials

Desire of a firm to take advantage of opportunities which present themselves at unexpected moments and which are typically outside the normal course of business is known as speculative motive.

1. 2. 3.

It is done to take advantage of: An opportunity to purchase RMs at a reduced price on payment of immediate cash. Investment in securities Buying raw materials when decline in price is anticipated.

The minimum balance that every firm needs to have in its current account with a bank cannot be used by the bank for transaction purpose and thus becomes a sort of investment by the firm which is
called compensating

motive for holding cash.

Objective of Cash management

To provide cash needed to meet the obligations
To minimize the idle cash held by the firm

Balance is to be struck between holding too much cash and too little cash.

Factors determining cash needs

Synchronization of cash flows

Short Costs: Expenses incurred as a result of shortfall in cash (a) Transaction cost (brokerage incurred in selling marketable securities)
(b) Borrowing costs (interest on loan etc.)

(c) Loss of cash discount

(d) Cost associated with deterioration of credit

rating (refusal to sell, loss of image, higher bank charges on loans, stoppage of supplies, loss of image, demand for cash payment)
(e) Penalty rates

Excess cash balance costs/opportunity costs

 Procurement and management (costs

associated with operating cash mgt staff like salary, storage, handling of securities)

Uncertainty and cash management

(unexpected delays in collection and disbursements, defaults and unexpected cash needs)

Determining cash needs

Preparing cash budget

Minimizing cost models

Cash budget: A Management Tool

Cash budget is a statement showing the receipts (inflows) and disbursement (outflows)of cash that is used to estimate its short term requirements Net cash position (surplus/deficiency) is highlighted by the cash budget.

Purposes of cash budgets

To coordinate timings of cash needs Pinpoints the periods when there is likely to be shortage or excess of cash Enables a firm which has sufficient cash to take advantage of cash discounts, pay obligations when due,

formulate dividend policy etc.

Helps to arrange needed funds on the favorable terms

and prevents accumulation of excess funds

Steps in preparation of Cash Budget

Selection of a period of time to be covered by the

budget (planning horizon).

Selection of factors that have a bearing on cash

flows. Only cash items are included in the budget.

Preparation of cash budget

Factors that generate cash flows are mainly divided into two
Operating

Financial

Operating cash flows

Inflows Cash sales Collection of accounts receivable Disposal of fixed assets Outflows Accounts payable Purchase of RMs Wages and salary Factory expenses Administrative and selling expenses Maintenance expenses

Purchase of fixed assets

Financial cash flows

Inflows Loans/borrowings Sale of securities Interest received Dividend received Rent received Refund of tax Issue of new shares Outflows Tax payment Redemption of loan Repurchase of shares Interest paid Dividends paid

Optimum cash balance

If there is shortage or surplus of funds at any

point of time then appropriate means of overcoming the shortage or managing the surplus must be explored.
Shortage: convert marketable securities to cash Surplus: convert cash to marketable securities

Thus optimum cash balance must be found out which is a trade-off between risk and return of maintaining cash balance.

BAUMOLs model
Same as economic order quantity model of inventory

management.

The model tries to strike a balance between opportunity

cost (holding cost) of holding cash against the transaction cost of converting cash into marketable securities or viceversa.

C=

2 AF/O

Where C= OPTIMUM BALANCE

A= TOTAL CASH DISBURSEMENTS F= FIXED COST PER TRANSACTION 0= OPPORTUNITY COST OF HOLDING CASH

BAUMOLS MODEL
TOTAL COST

COSTS

OPP. COST/HOLDING COST

TRANSC. COST

OPTIMUM CASH BALANCE

CASH BALANCE

ASSUMPTIONS
Cash needs of the firm are known

for certainty Cash disbursements of the firm occurs uniformly over a period of time and is known with certainty. Opportunity cost and transaction cost are known and remain constant throughout.

CRITICISMS
The model assumes a constant rate of use of cash

which is not always possible

The transaction cost will also be difficult to measure

since that depends on the type and maturity of investments

Miller-Orr model
This model overcomes the demerits of Baumols model of

uncertainty of cash flows.

Assumption here is cash balance of a firm may fluctuate

irregularly over a period of time.

The model has two control limits for cash balance H and

L.

 H is the upper limit beyond which cash balance need not be allowed to go. L is the lower limit below which cash level is not

allowed to reduce.
Cash balance should be allowed to move within

these limits.
If cash balance reaches H a part of cash should be invested in marketable securities so that cash balance comes down to the predetermined level called the RETURN LEVEL- R.

 If cash balance reaches L sufficient marketable securities should be sold to realize cash so that cash balance is restored to the RETURN LEVEL R.

The spread between the lower and the upper limit computed by the model is that which minimizes the sum of transaction cost and the opportunity cost.

1. 2.

Thus 3 steps are required: Lower limit/minimum cash balance

Estimating variability in future cash flows (based on past experience)

3. Computing spread as a function of the

variability, transaction cost and the interest rate. The spread is added to the lower cash limit in order to find out the upper cash limit of the firm.

1/3

3/4 X Transaction cost X variance of cash flows Z=

interest rate/day

Upper Limit= Lower Limit +3Z Return point = lower limit + Z Average cash balance = Lower Limit +4/3 Z Variance of cash flows= (standard deviation)2

Cash Management Techniques

Objectives of cash management

There should not be significant deviation between projected

cash flows and actual cash flows and to achieve this cash management efficiency will have to be improved through

proper control of cash collection and disbursement.

Twin objective

1.

To accelerate cash collection as much as possible

2. To decelerate or delay cash disbursements as much as

possible

Accelerating Cash Collections

Speedy cash collections

Customers should be encouraged to make the payment as soon as possible 2. Payments from customers should be converted into cash without any delay. Prompt payment by customers 1. Prompt billing and invoicing 2. Offering cash discounts Early conversion of payments into cash 1. Prompt encashment (there is a time lag between the time a cheque is prepared and mailed by a customer and finally it comes to the firm)
1.

Deposit Float
Within this time there are 3 steps involved a) Transit or mailing time (Postal Delay) b) Processing time( Lethargy) c) Collection Time(Bank Float)

Postal Delay+ Lethargy+Bank Float= Deposit Float

Deposit Float is defined as the sum of cheques written by customers that are not yet usable by the firm. However through decentralized collection the deposit float may be reduced.

Decentralized Collection reduces

The amount of time that elapses between

mailing of a payment by a customer

The point the funds become available to the

firm for use

Methods of establishing a decentralized collection network are

Concentration Banking
Lock-Box System

Slowing Disbursements
Avoidance of early payments Centralized disbursements

Float (Paying from a distant bank & Cheque

encashment analysis
Accruals