MODULE 2

CASH MANAGEMENT

By: Hiren Lathiya

Cash is the important current asset, which a firm can disburse
immediately without any restriction.
Facets of cash Management
i. Cash flows into and out of the firm
ii. Cash flows within the firm
iii. Cash balances held by the firm at a point of time by
financing or investing in surplus fund.
 Motives for holding cash
a. The transaction motive- payment of wages, interest, taxes,
etc
b. The precautionary motive- floods, strikes, increase in raw
material prices
c. The speculative motive –to invest in more profitable
opportunities
d. Compensating Motive - is a motive for holding cash to
compensate banks for providing certain services or loans.
Cash planning :
It is the technique to plan and control the use of cash. It helps
to anticipate the future cash flows and needs of the firm and
reduces the possibility of idle cash balances and cash deficits.

Cash forecasting and budgeting
Cash budget is the most significant device to plan for and
control cash receipts and payments
Information on the timing and magnitude of expected cash
flows.
 Functions of short term cash forecasts
To determine the operating cash requirements
To anticipate short financing
To manage investment of surplus cash
Scheduling payments in connection with capital expenditure
Taking advantage of cash discounts
Guiding credit policies
 Strategies for managing surplus cash
1. Do nothing
2. Make Ad hoc investments
3. Ride the yield curve
4. Develop guidelines
i. Do not speculate on interest changes
ii. Hold marketable securities till they mature
iii. Minimize transaction cost and so on
5. Utilize control limits
6. Manage with a portfolio perspective
a. Define the efficient frontiers
b. Select the optimal portfolio
7. Follow a mechanical procedure
 Optimum cash balance under certainty:
Baumol’s model of cash Management
It is a formal approach for determining a firm’s optimum cash
balance under certainty
Here the firm attempts to minimise the sum of the cost of
holding cash and cost of converting marketable securities to
cash.
Assumptions
i. The firm is able to forecast its cash needs with certainty.
ii. The firm’s cash payments occur uniformly over a period of
time
iii. The opportunity cost of holding cash is known and it does
not change over time.
iv. The firm will incur the same transaction cost whenever it
 Cash balance

C/2 Averag
e

time
0 T1 T2

Baumol’s model for cash balance

Holding cost
The firm incurs a holding cost for the keeping the cash
balance.
Holding cost is an opportunity cost: that is, the return foregone
on the marketable securities.
Holding cost = k(C/2)

Transaction cost
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.
If per transaction cost is c, then the total transaction cost will
be.
Total cost = k(C/2) + c (T/C)
Optimum level of cash balance ( C*)
The holding cost increases as demand for cash increases, but
transaction cost decreases because no. of transaction will
decline and vice versa.
Thus there is trade of between holding cost and transaction
cost.
Optimum cash balance is obtained when total cost is
minimum. 2cT
k
C* =
Optimum cash balance under uncertainty
Miller-Orr model of cash management
The limitation of the Baumol model is that it does not allow
the cash flows to fluctuate.
The Miller-0rr model over comes this shortcomings
MO model provides for two control limits- Upper control
limit(UCL) and Lower Control limit (LCL) as well as Return
point.
If firm’s cash flows fluctuate randomly and the hit the UCL,
then it buys sufficient securities to come back to normal level
(return point).
When firm’s cash flows hit the LCL, it sells sufficient
securities to bring the cash balance to the normal level (return
point).
The firm sets the lower control limits as per its requirement of
maintaining cash balance
The difference between the upper limit and the lower limit
depends on the following factors:
a. The transaction cost (c)
b. The interest rate (i)
c. The standard deviation (σ) of net cash flows.

 The upper and lower limits will be far off from each other if
transaction cost is higher or cash flows show greater
fluctuations.
 This limits come closer as the interest increases.
The UCL is three times above the LCL.
Thus,
UCL= Lower limit + 3Z
Return point = Lower limit +Z

Average cash balance = lower limit + 4/3 Z

 Speeding up collections
 The collection time comprises mailing time, cheque processing
delay and availability delay
Lock box system
Under this system customers are advised to mail their
payments to special post office boxes called “lock boxes”
Which are attend too by local collecting bank instead of
sending them to firm
The local bank collects the cheque from the lock box during
the day and deposits the cheque directly into the local bank
account of the firm.