CASH MANAGEMENT AND ITS

MODELS
 INTRODUCTION
Cash is the important current asset for the operations of the business. It is
basic input needed to keep the business running on a continuous basis, it is
also the ultimate output expected to be realized by selling the service or
product manufactured by the firm. The firm should keep sufficient cash,
neither more nor less.
Cash Management is concerned with the managing of: (i) cash flows into and
out of the firm, (ii) cash flows within the firm, and (iii) cash balances held by
the firm at a point of time by financing deficit or investing surplus cash. Cash
Management assumes more importance than other current assets because
cash is the most significant and the least productive asset that firm holds. It is
significant because it is used to pay the firm’s obligation. However, cash is
unproductive. Unlike fixed assets or inventories, it does not produce goods for
sale.
 OBJECTIVES OF CASH
MANAGEMENT
Fulfil Working Capital Requirement: The organization needs to maintain ample liquid
cash to meet its routine expenses which possible only through effective cash management.
Planning Capital Expenditure: It helps in planning the capital expenditure and determining
the ratio of debt and equity to acquire finance for this purpose.
Handling Unorganized Costs: There are times when the company encounters unexpected
circumstances like the breakdown of machinery. These are unforeseen expenses to cope up
with; cash surplus is a lifesaver in such conditions.
Initiates Investment: The other aim of cash management is to invest the idle funds in the
right opportunity and the correct proportion.
Better Utilization of Funds: It ensures the optimum utilization of the available funds by
creating a proper balance between the cash in hand and investment.
Avoiding Insolvency: If the business does not plan for efficient cash management, the
situation of insolvency may arise. It is either due to lack of liquid cash or not making a profit
out of the money available.
 FUNCTIONS OF CASH
MANAGEMENT
Investing Idle Cash: The company needs to look for various short term
investment alternatives to utilize surplus funds.
Controlling Cash Flows: Restricting the cash outflow and accelerating the
cash inflow is an essential function of the business.
Planning of Cash: Cash management is all about planning and decision
making in terms of maintaining sufficient cash in hand and making wise
investments.
Managing Cash Flows: Maintaining the proper flow of cash in the organization
through cost-cutting and profit generation from investments is necessary to
attain a positive cash flow.
Optimizing Cash Level: The organization should continuously function to
maintain the required level of liquidity and cash for business operations.
 MOTIVES FOR HOLDING CASH
Transaction Motive: The Transaction Motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for
purchases, wages and salaries, other operating expenses, taxes, dividends etc. the need to hold cash would not arise if there were perfect synchronization between cash
receipts and cash payments, i.e., enough cash is received when the payment has to be made. For those periods when cash payments exceeds cash receipts, the firm
should maintain some cash balance to be able to make required payments. For transactions purpose, a firm may invest its cash in marketable securities. Usually, the firm will
purchase securities whose maturity corresponds with some anticipated payments, such as dividends, or taxes in the future.
Precautionary Motive: The Precautionary Motive is the need to hold cash to meet contingencies in the future. It provides a cushion or butter to withstand some unexpected
emergency. The precautionary amount of cash depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will be maintained for an
emergency. The amount of precautionary cash is also influenced by the firm’s ability to borrow at short notice when the need arises. Stronger the ability of the firm to borrow
at short notice, less will be the need for

 \
precautionary balance. The precautionary balance may be kept in cash and
marketable securities. Marketable securities play an important role here. The amount
of cash set aside for precautionary reasons is not expected to earn anything;
therefore, the firm should attempt to earn some profits on it. Such funds should be
invested in high liquid and low risk marketable securities. Precautionary balance,
thus, should be held more in marketable securities and relatively less in cash.
Speculative Motive: The Speculative Motive relates to holding of cash for
investing in profit-making as and when they arise. The opportunity to make profit
may arise when the security prices change. The firm will hold cash, when it is
expected that interest rate will rise and security prices will fall. Securities can be
purchased when the interest rate is expected to fall; the firm will benefit by the
subsequent fall in interest and increase in security prices. The firm may also
speculate on materials’ prices. If it is expected that materials’ prices will fall, the firm
can postpone materials’ purchasing and make purchases in future when price
actually falls. Some firms may hold cash for speculative purposes. By and large,
business firms do not engage in speculations.
 CASH PLANNING

Cash Planning 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 (which lowers firm’s profitability) and cash deficits (which can
cause the firm’s failure). Cash planning protects the financial condition of the firm by
developing the projected cash statement, from a forecast of expected cash inflows
and outflows, for a given period.

CASH FORECASTING
Cash budget is the most significant device to plan for and control cash receipts and
payments. A cash budget is a summary statement of the firm’s expected cash inflows
and outflows over a projected time period. Cash Forecasts are needed to prepare
cash budgets. Cash forecasting may be done on short or long-term basis. Generally,
forecasts covering periods of one year or less are considered short-term; those
extending beyond one year are considered long-term.
 SHORT-TERM CASH FORECASTING
It is comparatively easy to make short-term forecasts. The short-term forecasts helps in
determining the cash requirements for a predetermined period to run a business. The important
functions of carefully developed short-term cash forecasts are:
• To determine operating cash requirements
• To anticipate short-term financing
• To manage investment of surplus cash

SHORT-TERM FORECASTING METHODS

RECEIPT AND DISBURSEMENTS METHOD
The Receipts and Disbursements Method is generally employed to forecast for limited
periods, such as a week or a month. The cash flows can be compared with budgeted income
and expenses items if the Receipts and Disbursements Approach is followed.
Under this forecasts of cash inflows and outflows are developed for a definite period and
then they are combined to obtain net cash inflows and outflows. And this net balance would
indicate whether the firm has excess cash of deficit.
MERITS
•It gives a complete picture of all the items of expected cash flows
•It is a sound tool of managing daily cash operations
DEMERITS
•Its reliability is reduced because of the uncertainty of cash forecasts
•It fails to highlight the significant movements in working capital items

ADJUSTED NET INCOME METHOD

The Adjusted Net Income Method is preferred for longer durations ranging from few
months to a year. The Adjusted Income Approach is appropriate in showing a company’s
working capital and future financing needs.
It is also known as Sources and Uses Approach.
Objectives of this method are:
•To project the company’s need for cash at a future date
•To show whether the company can generate the required funds internally, if not, how
much will have to be borrowed or raised in the capital market
MERITS
•It highlights the movements in the working capital items, and thus, helps to keep a control
on a firm’s working capital
•It helps in anticipating a firm’s financial requirements
DEMERITS
•It fails to trace cash flows and therefore, its utility in controlling daily cash operations is
limited
 LONG-TERM FORECASTING
Long-term cash forecasts are prepared to give an idea of the company’s financial
requirements in the distant future. They are not detailed as the short-term forecasts are.
Once a company has developed a long-term cash forecast, it can be used to evaluate the
impact of, say, new product developments or plant acquisitions on the firm’s financial
condition, for three, five or more years in the future. Major uses of long-term cash
forecasting:
• It indicates as company’s future financial needs, especially its working capital
requirements.
• It helps to evaluate proposed capital projects. It pinpoints the cash required to finance
these projects as well as the cash to be generated by the company to support them.
• It helps to improve corporate planning. Long-term cash forecasts compel each division to
plan for the future and to formulate projects carefully.
Long-term cash forecasts may be made for two, three or five years. As with the short-term
forecasts, the company’s practices may differ on the duration of long-term forecasts to suit
its particular needs.
 ACCELERATING CASH COLLECTIONS

A firm can conserve cash and reduce its requirements for cash balances if it can speed up its
cash collections. The first hurdle in accelerating the cash collection could be the firm itself. It
may take along time to process the invoice. Days taken to get the invoice to buyers adds to
order processing delay. A firm can use decentralized collection system and lock-box system to
speed cash collections and reduce deposit float.
The amount of cheques sent by customers which are not yet collected is called deposit
collection or deposit float.

Decentralization Collections: A large firm operating over wide geographical areas can
speed up its collections by following a decentralized collection produce . A decentralized
collection produce ,called concentration banking in USA ,is a system of operating through a
number of collection centers, instead of single collection Centre centralized at the firm`s head
office.
The basic purpose of the decentralized collections is to minimize the lag between the
mailing time from customers to the firm and the time when the firm can make use of
funds.
Lock-box System: Lock-box System helps the firm to eliminate the time between the
receipt of cheques and their deposit in the bank.
In this system, the firm establish a number of collection centres, considering customer
locations and value of remittances. At each centre, the firm hires a post office box and
instructs its customer to mail their remittances to the box.
The firm’s local bank is given the authority to pick up the remittances directly from the
local box. The bank picks up the mail several times a day and deposits the cheques in the
firm’s account. For the internal accounting purposes of the firm, the bank prepares
detailed records of the cheques picked up.
This system involves cost, bank charges a fee or requires a minimum balance to be
maintained.
 CASH COLLECTION INSTRUMENTS IN INDIA
AND THEIR FEATURES

INSTRUMENT PROS CONS

1. CHEQUES • No charge • Can bounce
• Payable through clearing • Collection times can be long
• Can be discounted after receipt • Collection charge
2. DRAFTS • Payable in local clearing • Cost of collection
• Chances of bouncing are less • Buyers account debited on one day

3. DOCUMENTARY • Low discounting charge • Not payable through clearing

BILLS • Theoretically, goods are not released
till payments are made or the bill is
accepted
4. TRADE BILLS • No charge except stamp duty
• Can be discounted
• Discipline of payment on due date
5. LETTERS OF • Good credit control as goods are
CREDIT released on payment or acceptable
• Seller forced to meet delivery schedule
because of expiry date
• High collection cost
• Long delays
• Procedure is relatively cumbersome
• Buyers are reluctant to accept the
due date discipline
• Opening charges
• Transit period interest
• Negotiation charges
 CLEARING

The instrument of exchange (e.g., cheques, drafts, etc.) are used to receive or pay
claims. The Clearing Process refers to the exchange by banks of instruments drawn
on them, through a clearinghouse e.g.: cheque, demand drafts, interest and
dividend warrants and refund orders can go through clearing. Documentary bills, or
promissory notes do no go through clearing.
The clearing process has been highly automated in a number of countries. Banks in
India have started using MICR (Magnetic Ink Character Recognition) to automate the
clearing process. They maintain an account with Reserve Bank of India (RBI) which
is debited for inward clearing (items drawn on plus outward returns) and credited for
outward clearing (items drawn on other banks plus inward returns).The RBI is now
planning to implement a pan-India Cheque Truncation System from September 2020. Those
who use cheques can expect clearing to become faster and safer across the country with the
Reserve Bank of India (RBI) now planning to implement a pan-India Cheque Truncation
System (CTS) from September 2020.
 CONTROLLING DISBURSEMENTS

• The effective control of disbursement can also help the firm in conserving cash and
reducing the final requirements. Disbursement arise due to trade credit, which is a
(spontaneous) source of funds. The firm should make payments using credit terms to the
fullest extent. There is no advantages in paying sooner than agreed. By delaying payments
as much as possible, the firm make maximum use of trade credit as a source of funds- a
source which is interest free. Delaying disbursements results in maximum availability of
funds. However, the firms that delay in making payments may endanger its credit standing.
• Disbursement or Payment Float: Some firm uses the technique of ‘playing the float’ to
maximize the availability of funds. When the firm’s actual bank balance is greater than the
balance shown in the firm’s books, the difference is called disbursement or payment
float. The difference between the total amount of cheques drawn on a bank account and
the balance shown on the bank’s books is caused by transit and processing delays. If the
finance manager can accurately estimate when the cheques issued will be deposited and
collected, he or she can invest the ‘float’ during the float period to earn a return. However,
it is very risky game and should be played very cautiously.
 CASH MANAGEMENT
MODELS
• Cash management requires a practical approach and a
strong base to determine the requirement of cash by the
organization to meet its daily expenses:
• The Baumol’s EOQ Model (Certainty Model)
• The Miller – Orr’ Model (Uncertainty Model)
 THE BAUMOL’S EOQ MODEL

 Based on the Economic Order Quantity (EOQ), in the year 1952 by William J.
Baumol. This model emphasizes on maintaining the optimum cash balance in a
year to meet the business expenses on the one hand and grab the profitable
investment opportunities on the other.
 The following formula of the Baumol’s EOQ Model determines the level of cash
which is to be maintained by the organization.

 Where,
‘C’ is the optimum cash balance;
‘F’ is the fixed transaction cost;
‘T’ is the total cash requirement for that period;
‘i’ is the rate of interest during the period
 THE MILLER – ORR’ MODEL
• According to Merton H. Miller and Daniel Orr, Baumol’s model only determines the cash withdrawal.
• This model emphasizes on withdrawing the cash only if the available fund is below the return point of
money whereas investing the surplus amount exceeding this level.
• ‘Z’ is the spread of cash;
‘UL’ is the upper limit or maximum level
‘LL’ is the lower limit or the minimum level
‘RP’ is the Return Point of cash

Where,
‘Return Point’ is the point at which money is to be invested or withdrawn;
‘Minimum Level’ is the minimum cash required for business sustainability;
‘Z’ is the spread across the minimum level and the maximum level;
‘T’ is the transaction cost per transfer;
‘V’ is the variance of daily cash flow per annum;
‘i’ is the daily interest rate
 Calculated Annual Requirement of Cash : 10,00,000
Act 1 Act 2 Act 3 Act4

Lot Size ₹10,00,000 ₹5,00,000 ₹1,00,000 ₹50,000

No. Of Transactions 1 2 10 20

Transaction Cost Minimum Maximum

(₹100/txn) ₹100/- ₹2000/-

Opportunity Maximum Minimum

Cost/Interest
Foregone

Optimum cost will be obtained by calculating the total cost and by one of the methods and obtaining a balance between the above
variables
 INVESTING SURPLUS CASH IN
MARKETABLE SECURITIES

There is a close relationship between cash and money market securities or other short-term
investment alternatives. Investment in these alternatives should be properly managed.
Excess cash should normally be invested in those alternatives that can be conveniently and
promptly converted into cash. Cash in excess of the required of operating cash balance may
be held for two reasons:
• First, the working capital requirement of the firm fluctuates because of the elements of
seasonality and business cycle. The excess cash may build up during slack season but it
would be needed when the demand picks up. Thus, excess cash during slack season is
idle temporarily, but has a predictable requirement later on.
• Second, excess cash may be held as a buffer to meet unpredictable financial needs. A firm
holds extra cash because cash flows can not be predicted with certainty. Cash balance
held to cover the future exigencies is called the precautionary balance and is usually
invested in the short-term money market investment until needed.
 SELECTING INVESTING
OPPORTUNITIES
A firm can invest its excess cash in many types of securities or short-term investment
opportunities. As the firm invests its temporary cash balance, its primary criterion in selecting a
security or investment opportunity will be its quickest convertibility into cash, when the need for
cash arises. In choosing among alternative investments, the firm should examine three basic
features of security:
• Safety: Usually, a firm would be interested in receiving as high a return on its investment as is
possible. But the higher returns-yielding securities or investment alternatives are relatively more
risky. The firm would invest in very safe securities as the cash balance invested in them is
needed in near future.
• Maturity: Maturity refers to the time period over which interest and principal are to be made. The
price of long-term security fluctuates more widely with the interest rate changes than the price of
short term security. Over time, interest rate has tendency to change. Because, of these two
factors, the long-term securities are more risky. For safety reason, therefore, the firms of the
purpose od investing excess cash prefer short-term securities.
• Marketability: Marketability refers to convenience and speed with which a security or an
investment can be converted into cash. The two important aspects of marketability are price and
time. If the security can be sold quickly without loss of price, it is highly liquid or marketable.
 TYPES OF SHORT-TERM INVESTM ENT
OPPORTUNITIES

• Commercial Papers: Commercial paper’s (CPs) are short-term, unsecured securities issued by highly
creditworthy large companies. They are issued with the maturity of three months to one year. CPs are
marketable securities, and therefore, liquidity is not a problem.
• Certificate of Deposits: Certificate of deposits (CDs) are papers issued by banks acknowledging fixed
deposits for a specific period of time. CDs are negotiable instruments that make them marketable
securities.
• Bank Deposits: A firm can deposit its temporary cash in a bank for a fixed period of time. The interest
rate depends on the maturity period. The default risk in most of the bank deposits is quite low.
• Inter-corporate Deposits: ICDs is a popular short-term investment alternatives for companies in India.
Generally a cash surplus company will deposit (lend) its funds in a sister or associate company or with
outside companies with high credit standing. The risk of default is high, but returns are quite attractive.
• Money Market Mutual Funds: MMMFs focus on short-term marketable securities such as TBs, CPs,
CDs, or call money. They have a minimum lock-in period of 30 days, after this period, an investor can
withdraw his or her money at a short notice or even across the counter in some cases. They offer
attractive yields. MMMFs are recent origin in India, and they have become quite popular with
institutional investors and some companies.
 LIMITATIONS OF CASH MANAGEMENT

• Cash management is an inevitable part of business organizations. However,

it has a few shortcomings which make it unsuitable for small organizations;
these are as follows:
• Cash management is a very time consuming and skilful activity which is
required to be performed regularly.
• As it requires financial expertise, the company may need to hire consultants
or other experts to perform the task by paying administrative and
consultation charges.
• Small business entities which are managed solely, face problems such as
lack of skills, knowledge, time and risk-taking ability to practice cash
management.
 CONCLUSION
• Lack of control over cash flows and inefficient cash management
can be harmful to the business. Cash management solves all the
problems pertaining to the deficiency in working capital. It also
ensures that the solvency of a company is not impacted and the
current value of money is more effectively taken into use along with
speeding up the company’s operational activities. However, it must
be noted that it is not a substitute for profit and loss statements.
• More often than not, it is the improper management of cash that has
caused businesses to fail. Effective Cash Management is therefore
a necessity for businesses.