Cash management

The key issues in cash management

Estimation of cash requirements through cash budgets Reports and control Monitoring collections and receivables Optimal cash balance Investment of surplus funds

Focus of Cash management

Matching inflows with the outflows Shortage and surplus management To balance liquidity and profitability

 Cash budgets

Cash budgets are planning tools

Short term budgets
For a period less than a year- to cater to the operational requirements

Long term budgets

For a period than a year- to cater to the long term fund requirements
The short term budgets are prepared based on forecasted receipts and payments method The long term budgets are prepared based on sources and uses of funds

Cash reports are controlling tools

Daily reports Weekly reports Monthly reports

Cash reports

1 2

Opening Balance Receipts sales - Collection - Loans - Other receipts Payments Purchases - Payments to creditors - Loan repayments - Asset purchase & other payments Net Cash flow (2-3)

Closing Balance (1+4)

Treasury Reports Reports all liquidable CAs

1 Opening Balance Cash - Securities - Receivables Purchase of the above

3 4

Sales of the above Closing Balance (1+2)-3

Cash collection and disbursements

Speed up the collection process Delaying payments

Optimal cash Balance

Optimum Cash Balance under Certainty: Baumols Model Optimum Cash Balance under Uncertainty: The MillerOrr Model

Baumols ModelAssumptions
The firm is able to forecast its cash needs with certainty. The firms cash payments occur uniformly over a period of time. The opportunity cost of holding cash is known and it does not change over time. The firm will incur the same transaction cost whenever it converts securities to cash.

 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 firms holding cost for maintaining an average cash balance is as follows:
Holding cost = I(C/2)

C/2= Average cash balance for the period I= interest rate on marketable securities

 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 = F(T/C) F=Fixed transaction cost T=total demand for cash during a specified period

The total annual cost of the demand for cash will be: Total cost = I(C/2)+F(T/C) The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for the optimum cash balance is as follows: 2 FT C=
I

Illustration
Suppose ABC Ltd expects total cash payments over a period of 2 months to be Rs.100000, while fixed costs per transaction is Rs.100 and the interest rate on marketable securities is 12% p.a. a. Determine optimum cash balance using Baumol model b. What is the total cost at this level

C=

2 FT I
2 x1000000 x100 .02
C= Rs.31623

TC=

100000 31623 ( )100 0.02( ) 31623 2

TC=316.2+316.2 =632.44

 Advani Chemical Limited estimates its total cash requirement as Rs 2 crore next year. The companys opportunity cost of funds is 15% per annum. The company will have to incur Rs 150 per transaction when it converts its short-term securities to cash. Determine the optimum cash balance. How much is the total annual cost of the demand for the optimum cash balance? How many deposits will have to be made during the year?

C=

2 x 2 x150 0.15

C= Rs.200000 TC = ( 20000000)150 0.15( 200000)

200000 2
TC= 15000+15000 TC= 30,000 During the year, the company will have to make 100 deposits, i.e. converting marketable securities to cash.

27.3
Sanman ltd requires Rs2.5 million cash over next 6 months. Currently it holds marketable securities. Company earns 10% on its securities. The conversion of the securities costs Rs.1200 per transaction. What is the optimal cash size as per Baumols model/

C=

2 x 2500000 x1200 0.05

C= Rs.346410

 EOQ model of Baumol cannot be relied when there is unpredictable cash requirements. There are extreme cash points and fluctuations cannot be predicted Set the control limit
Upper limit Lower limit Return point

The MillerOrr Model

If the firms 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 firms 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).

Illustration
Interest rate is 12% p.a. A transaction of buying and selling securities cost Rs.1600. The standard deviation of the change in daily cash balance is Rs.5000. The management would like to maintain a minimum cash balance of Rs.50,000 a. Determine the Return point b. Upper limit of cash balance

RP =

3 F 2 4I

+LL

I= 0.12 / 360 = 0.000333

4x0.00033 = 0.00132
3x1600x(5000x5000) =120,000,000,000
3

1200000000 00 0.00132
= 44962.5+50000 = 94962.5 UL = 3x94962.5 2x50000 = 184887

+ 50000

27.4
Avinash Company expects its cash flow to behave in a random manner. The co expects to establish the Upper control limit and the return point based on the following information
The annual yield on marketable securities is 12% The fixed costs of transaction is Rs.1200 The standard deviation in the change in daily cash balance is Rs.6000 The Co expects to maintain a minimum cash balance of Rs. 100,000

RP =

3 F 2 4I

+LL

I= 0.12 / 360 = 0.000333

4x0.00033 = 0.00132
3x1200x(6000x6000) =129,600,000,000

1296000000 00 0.00132
= 46133+100000 = 146133 UL = 3x146133 2x100000 = 438399 200000 = 238399

+ 100000

Investment of surplus funds

Criteria
Liquidity Safety Return

Avenues
Inter corporate deposits/ lending T-bills Certificate of deposits Commercial paper ST bank deposits Bill discounting

Cash budgets
A firm makes 80% of its sales on 30 days credit basis. 80% of the sales is collected after one month and remaining in the 2nd month. Calculate the expected cash reciepts based on the sales forecasts available for the month Nov 12 to Apr 13 Nov Dec Jan feb Mar Apr 500 600 550 660 700 1000