Management of Inventory

UNIT 6 MANAGEMENT OF CASH

Objectives
The objectives of this unit are to:

Highlight the role of cash in the operation of business.

Explain different motives behind holding the cash.

Discuss various determinants that affect and create uncertainty in the cash flows.

Stress the importance of cash forecasting and techniques of forecasting.

Discuss the importance of managing cash surplus and cash-in-transit.

Explain the need for good management information system in cash management.

Structure
6.1
6.2
6.3
6.4
6.5
6.6
6.7
6.8
6.9
6.10
6.11
6.12

Introduction
Motives of holding cash
Determinants of Cash Flows
Cash Forecasting
Managing Uncertainty In Cash Flow Forecast
Managing Surplus Cash
Managing Cash-in-transit
MIS in Cash Management
Summary
Key Words
Self Assessment Questions
Further Readings

6.1

INTRODUCTION

Cash is basic input to start a business unit. Cash in initially invested in fixed
assets like plant and machinery, which enable the firm to produce products and
generate cash by selling them. Cash is also required and invested in working
capital. Investments in working capital are required because firms have to store
certain quantity of raw materials and finished goods and provide credit terms to
the customers. The cash invested in raw materials at the beginning of working
capital cycle goes through several stages (work-in-progress, finished goods and
sundry debtors) and gets released at the end of cycle to the fund fresh
investment needs of raw materials. The firm needs additional cash during its life
whenever it needs to buy more fixed assets, increase the level of operations and
any change in working capital cycle such as extending credit period to the
customers. In other words, the demand for cash is affected by several factors
and some of them are within the control of the managers and others are outside
the control of the managers. Cash management thus, in a broader sense is
managing the entire business.
In the context of working capital management, cash management refers to
optimising the benefits and costs associated with holding cash. As described
earlier, unless the cash is put into use, there is no benefit derived out just by
holding it. Further, holding cash without a purpose also costs firm either directly
in the form of interest or opportunity income that could be earned out of the
cash. At the same time, it is not possible to operate the business without holding
cash. Many of us take cash while going to office though we have bought the
tickets earlier and taking lunch with us or have a credit facility to take lunch.

Management
of Current
Though
no major
demand for cash is expected, we feel uncertain without cash.
Assets
Firms also feel uncertain without holding cash for various reasons. For instance,
any delay in collection will force the firm to delay the salary to employees or
payment to creditors or bankers which in turn affects long-term relationship with
them. Firms, which are experiencing volatile price behaviour in some of the
critical raw materials, would like to have more cash to buy the material,
whenever the price is low. There are several other motives of holding cash and
we will shortly discuss these motives in detail.

The objective of cash management is to balance the cost associated with holding
cash and benefits derived out of holding the cash. The objective is best achieved
by speeding up the working capital cycle, particularly the collection process and
investing surplus cash in short-term assets in most profitable avenues. The term
cash under cash management thus refers to both cash and credit balance in the
bank and short-term investments in marketable securities. Table 6.1 shows total
amount invested in cash and marketable securities of few industries. The figures
in the Table shows that investment in cash and marketable securities is huge and
has gone up several times in reflection to growth of operations. Investments in
cash and marketable securities also show significant differences between
industries even after taking into account the differences in the number of firms in
different industries.
Table 6.1: Investments in Cash and Marketable Securities of Manufacturing Industries
(Rupees in Crores)
Industry

1999

2000

2001

2002

2003

Food & Beverages

2306.34

2424.03

2372.82

2585.53

3014.78

Textile

2460.09

1884.74

2489.38

2506.74

2625.73

12287.85

13337.33

13618.50 17504.49

18334.49

Non-metallic Minerals Products 1289.58

1135.09

1369.33

1349.02

1449.67

Metals & Products

5143.03

5188.58

6362.79

6050.11

7325.18

Machinery

8926.23

9986.02

11714.53 15334.53

18197.25

Transport Equipment

5998.40

5419.28

5744.91

5871.66

7933.06

Diversified

9852.56

9242.45

7208.94

7467.43

6849.64

721.01

1040.25

948.77

953.74

1617.11

48985.09

49657.77

51829.97 59623.25

67346.91

Chemicals

Miscellaneous
Total

Note: Figures in brackets indicate the number of companies of the industry used
to compile industry aggregates.
Thus, while structuring cash management policy, the firm has to consider the
internal business process and external environment. The important issues relating
to management of cash are:

Understanding the motives behind holding the cash;

Quantifying the cash needs of the firms to achieve the above motives; and

Developing a cash management model to enable operating managers to take

decisions on investing surplus cash and selling investment to fund shortage.

Activity 6.1
1) How do you relate cash management in a broader sense? What is its focus in
the context of working capital management?
.
2

2) Why do we need to manage cash?

Management of Inventory

.
.
.
3) Collect the cash and marketable securities data of your company or any one
company you are familiar with from published accounts for the last three or
five years. Examine the trend and its relationship with level of operation.
.
.
.

6.2

MOTIVES OF HOLDING CASH

Fixed assets are used to convert the raw materials into finished goods.
Investments in current assets cannot be avoided due to constraints in technology,
manufacturing process and customers behaviour of demanding different models at
a point close to her/his house and at the point of consumption. Inventory and bills
receivables have become essential to continue business operations more fruitfully.
Emphasis is always given to reduce the investments in these assets and thus
reduce the working capital cycle. Investment in cash and marketable securities
are the least productive assets. Often, firm is not dependent on this asset in the
manufacturing process nor is required for creating inventory or selling. Thus, the
basic question is why firms hold cash and marketable securities? Some of the
reasons for holding cash are listed below.
Transaction Motive: Money is required to settle customers bills, pay salary and
wages to workers, pay duties and taxes, etc. Some cash balance is to be
maintained to complete these transactions. The amount to be maintained for the
transaction motive depends on the cash inflows and outflows. Often, firms
prepare a cash budget by incorporating the estimates of inflows and outflows to
know whether the cash balance would be adequate to meet the transactions.
Precautionary or Hedging Motive: The transaction motive takes into account
the routine cash needs of the firm. It is also based on the assumption that
inflows are as per estimation. However, the future cash needs for transaction
purposes are uncertain. The uncertainty arises on account of sudden increase in
expenditure or delay in cash collection or inability to source the materials and
other supplies on credit basis. The firm has to protect itself from such
contingencies by holding additional cash. This is called as precautionary motive of
holding cash balance. Precautionary cash balance is also maintained to meet the
non-routine needs. Generally, cash required for precautionary motive is held in the
form of short-term securities with the objective to earn atleast some positive
return. The securities are sold and cash is realised as and when such
emergency demand for cash arises.
Speculative Motive: If the firm intends to exploit the opportunities that may
arise in the future suddenly, it has to keep some cash balance. The term
speculative motive to some extent is a misnomer since cash is not kept to
conduct any speculation but merely to exploit opportunity. This is particularly
relevant in commodity sector, where the prices of material fluctuate widely in
different periods and the firm's business success depends on its the ability to

Management
of Current
source
the material
at the right time. Some of the materials, whose prices show
Assets
significant volatility, are cotton, aluminium, steel, chemicals, etc. Surplus cash is
also used for taking over of other firms. Firms that intend to take advantage on
the above counts keep large cash balances with them, though the same are not
required either for transactions or as a precaution.

Managing uneven supply and demand for cash: Firms generally experience
some seasonality in sales, which leads to excess cash flows in certain period of
the year. This is not permanent surplus and cash is required at different points
of time. One possible solution to address this mismatch of cash flows is to pay
off bank loans whenever there is excess cash and negotiate fresh loan to meet
the subsequent demands. Since firms are exposed to some amount of
uncertainty in getting the loan proposal sanctioned in time, the surplus cash is
retained and invested in short-term securities.
In a competitive environment, firms also felt the desire of holding cash to get
flexibility in meeting competition. For instance, when a competitor suddenly
resort to massive advertisement and other product promotion, it forces other firms
to increase advertisement cost or some other sales promotion such as free gift
for every purchase or lottery scheme, etc. Amount held in the form of cash and
marketable securities of twenty manufacturing companies of BSE-30 Index
(Sensex) firms has increased from Rs. 20827.76 cr. in 1999 to Rs. 20094.91 in
2003 (Table 6.2).
Table 6.2 :Investments in Cash & Marketable Securities of Manufacturing Companies in
Sensex
(Rupees in Crores)
Company

1999

2000

2001

3878.12
2223.90
1807.72
4770.76
1461.26
1326.67
1491.27
7675.29
2378.12
3341.00
191.03
2191.60
265.08
8055.17
1763.74
1479.14
383.50
407.18
3505.76
466.20
1946.49
647.86
211.10
337.31
56.48
324.96

50326.59
5525.18
9722.93
15203.81
7660.84
6247.97
8431.65
15561.74
6767.00
20213.30
2585.45
9299.45
16888.20
36959.51
12889.90
4612.13
2988.98
1047.85
4570.49
3476.45
6376.15
2389.91
1066.85
1163.95
1146.54
1865.38

2002
25706.20
4183.43
8276.70
9784.78
2658.63
2991.17
3457.94
10016.02
3873.85
2622.43
1673.09
3068.67
7994.18
6825.49
3576.49
2114.79
618.90
637.02
796.41
901.24
2538.60
1327.16
550.40
674.47
674.65
600.89

2003

Oil & Natural Gas Corpn.

Bajaj Auto
Bharat Heavy Electricals
Hindustan Petroleum Corpn.
Hindalco Industries
Grasim Industries
Tata Power Co.
Larsen & Toubro
Hindustan Lever
HDFC
Wipro
Tata Motors
Mahanagar Telephone Nigam
Reliance Industries
Tata Iron & Steel Co.
Reliance Energy
Gujarat Ambuja Cements
Cipla
Zee Telefilms
Associated Cement Cos.
ITC
Ranbaxy Laboratories
Dr. ReddyS Laboratories
Hero Honda Motors
Satyam Computer Services
Bharti Tele-Ventures

2393.83
1150.11
537.43
672.22
928.75
446.21
660.62
291.52
1030.38
1623.57
37.12
877.38
1356.42
6425.93
735.70
519.87
272.15
94.55
18.10
80.06
445.73
50.41
44.01
83.56
38.28
13.85

2488.52
2331.03
2020.30
1743.80
1475.62
1217.34
1088.82
1075.50
917.38
883.78
848.84
750.64
698.41
648.33
628.80
465.55
209.07
145.88
145.42
114.13
105.80
44.70
22.92
13.58
10.75
0.00

Total

20827.76 52586.71 254988.20 108143.60 20094.91

Activity 6.2

Management of Inventory

1) Can we consider investments in cash and marketable securities as least

productive?
.
.
.
2) Why companies maintain huge cash and marketable securities despite they
being least productive assets? List down a few industries, where the demand
for cash for speculative motive would be more.
.
.
.
3) Analyse the data given in Table 6.2. Why do you feel that in some
companies the cash balance has gone up over the years whereas in a few
cases, it remains same or has gone down?
...
.
.

6.3 DETERMINANTS OF CASH FLOWS

Investments in cash and marketable securities depend on the cash flow of the
firm. Firms, which primarily sell the product against cash (e.g. petroleum
products, gold, etc.) may not require much cash balance to be maintained since
there is always cash inflows to the firm. Banks and insurance companies, which
receive cash on regular intervals, can work with smaller cash balance at branch
level. On the other hand, firms in a competitive industry which have to extend
credit to the customers need to maintain large amount of cash to meet different
motives of holding cash. Cash flows are also affected by several other factors,
which can be broadly classified into internal and external factors.
Internal Factors
Internal factors relate to policies of management relating to working capital
components and future growth plan. These factors are determined by the firm
and arising out of management decisions. The internal factors that affect the
cash flows of firms are discussed below.
Production-related policies: Production-related policies determine production plan,
which in turn affect, purchase of material and other components and level of
finished goods. For example, firms that follow production policy of manufacturing
for inventory and then selling the product in the market will normally carry high
volume of material and other inventory in order to ensure smooth production
process. The increase in purchase activity will demand more cash compared to
other firms, which follow order-based production policy. Similarly, if production
process is automated, then the demand for cash to pay wages to workers will
5

Management
Current
come
down of
significantly.
Firms following JIT, MRP, FMS, etc., could reduce the
Assets
general level of inventory and they also favourably contribute to the demand for
cash.

Policies on Discretionary Expenses: Expenses not directly connected to the

manufacturing process, which have some amount of flexibility in timing the
expenditure are called discretionary expenses. Examples of discretionary expenses
are Research & Development cost, advertisement, replacement of a machine
before its life, etc. Some of the discretionary expenditure is planned in advance
whereas in other cases, the need arises suddenly. The management policy on
sanctioning discretionary expenses has a bearing on the cash flow. If
management follows a flexible policy and allows the expenses after seeing the
current cash position, the pressure on cash will come down significantly.
Policies on Receivables: The policies on trade receivable, which is last stage of
operating cycle, affect the cash flow. The credit period and cash discount
together determine the flow of cash. While liberal credit policy delays cash flow,
attractive discount policy speeds up the collection process.
Financial Policies: Firms, which pursue active capital expenditure programme in
the form of new projects or expansion, need cash. While part of resources is
raised externally in the form of fresh debt or equity, the balance is expected from
the internal surplus. The financing policy of the firm determines the cash flow.
Internal funding is also expected to meet any delay in raising external sources.
These firms may require more cash to meet such eventuality. Similarly, the
dividend policy of the firm affects the cash flow. Firms, which follow liberal
dividend policy, will put pressure on internal cash flows.
Payment Polices: The ability to get credit terms for purchases of materials and
other products and services also affects the cash flow. If the firm maintains
creditworthiness, it could always find it easy to source material and other items
on credit basis. On the other hand, if materials and other items are to be bought
on cash basis or only limited credit period is available, the demand for cash
increases.
External Factors
External factors can be broadly classified into monetary and fiscal factors and
industry-related factors. These are discussed below.
Monetary and Fiscal Factors: The central bank (Reserve Bank of India)
periodically spells out monetary policies and through which influences the
availability of money. The monetary policy in turn is affected by the fiscal factors
of the country. In a liberal monetary policy regime, it will not be difficult to get
credit from banks as well as from suppliers of material and services. Thus, the
need for holding cash is thus limited to transaction motive. Cash required for
precautionary and speculative motives can be easily raised. Unit-2 on 'Operating
Environment of Workimg Capital' contains more discussion on monetary policy
issues.
Industry-related factors: Industry-related factors affect the cash flow in the
form of practices followed by other firms in the industry on terms of sale and
nature of material and services required. Cash flow will be positive in retail
industry. Cash flow will be cyclical for industries such as plantation and agrobased products. Cash flow is volatile in certain industries like entertainment and
hospitality industry. Cash flow is generally negative for manufacturing industries.
Depending on the nature of cash flow relating to the industry, the demand for
holding cash is determined.
6

Activity 6.3

Management of Inventory

1) Why do we need to analyse the cash flows to determine the balance to be

maintained in the form of cash and marketable securities?
.
.
.
2) List down the factors that affect the cash flows of the firm.
.
.
.
3) Name any three industries in which you expect a positive or negative cash flow.
.
.
.

6.4

CASH FORECASTING

The discussion in the previous section shows various factors that affect the cash
inflows and outflows. An understanding of determinants of cash inflows and
outflows alone is not adequate in managing cash. It is necessary to forecast
cash flows using our understanding on the determinants of cash flows of the
firm. Cash forecasting is the core of cash management. A firm, which is not
forecasting the cash flows as a part of managing the cash flows, will face
unanticipated cash shortage. In order to mitigate the unanticipated cash shortage,
typically the firm will either delay the payment process or resort to emergency
borrowing. Delay in payments to suppliers will affect the price or delay in
supply, causing increased cost or expensive production delays. Emergency
borrowing will also increase the cost of borrowings. A firm with surplus cash
flow will also find it difficult to manage the cash without a forecast. Since the
information on how long the surplus cash will remain is not known, there is no
way for the firm to effectively use the cash. If short-term surplus cash is
invested for long-term, it will create unanticipated cash shortage. Surplus cash
lying within the firm will also encourage operating managers to pile up the
inventory and resort to many unproductive investments. Thus, cash forecast is
inevitable in managing the cash.
A major problem in forecasting of cash flows is that it cannot be done
independently. The determinants are many as seen in the previous section and
also highly inter-related with other budgets. Cash forecast/budget integrates
several other forecasts.
Types of Cash Forecast: The cash forecasts generated by the firms can be
broadly differentiated under two dimensions: the length of periods included within
the cash forecast and the approaches to cash flows used in the cash forecast.
Cash forecasts are normally prepared for one-year period but the forecast is
broken down to several smaller periods like, quarterly, monthly or weekly cash
7
forecasts. The choice of particular periodicity depends on the volume of cash

Management
Current
flows,
natureof of
cash flows and the desirability of the management. Firms broadly
Assets
follow two approaches in the preparation of cash forecast. Under the direct
approach, firms forecast various receipts and payments items for different periods
and consolidate the forecasts into cash budget. Under indirect approach, firms
start with forecast of earnings and then add back all non-cash expenses and
deduct all non-cash revenues, to get cash forecast. This is similar to preparation
of funds flow/cash flow statement, which is normally prepared using historical
accounting information as a part of financial statement analysis.

The format of monthly cash budget is illustrated in Table 6.3. It lists out major
cash inflow and outflow that arise in the normal operation of business. The
example also shows how the cash deficit and cash surplus are dealt with to
maintain the minimum balance.
Table 6.3 : Monthly Cash Budget
Cash Flow Item
Beginning cash balance
Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead Expenses
S&A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Cash Available / -Needed (A)
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan (B)
Closing Cash Balance (A - B)

January

February

March

60000
415488
475488

66078
373392
439470

61320
368280
429600

Total for
the Quarter
60000
1157160
1217160

68648
49202.4
30160
51400
199410
276078
60000
216078

60960
42150
28290
48850
180250
259220
60000
199220

56957
44670
29130
50130
180887
248713
60000
188713

186565
136022.4
87580
150380
560547
656613
60000
596613

0
0
-210000

0
0
60000

0
0
-120000
-230000

2100

0
0
30000
-230000
1800

-210000
66078

-197900
61320

3900
-250000
-188200
60513

-250000
-596100
60513

Methods of Cash Flow Forecasting: The above Table gives the output as a
result of forecasting exercise. However, each item in the above Table requires
several computations and assumptions. While a few cash flow items are
independent, several others are dependent on many other variables. Forecasting
method depends on the nature of cash flows. Some of the common methods of
forecasting are explained below:
1. Independent Cash Flow Items: These cash flow items are independent of
other factors or predetermined. Lease rent for office building, property tax,
insurance premium, etc., are few items which are determined independently.
2. Dependent Cash Flow Items: Many cash flow items are dependent on
other financial variables. For instance, cash collection from sundry debtors
depends on sales of the previous months, credit terms and collection pattern.
An understanding of the relationship between the cash flow variables is
important in forecasting the cash flows. If only one variable is associated
with cash flow items, then estimation is not difficult. On the other hand, if
several variables are associated with a cash flow item, econometric models
are used to get the value. For instance, if customers take more than two
8

Inventory
months credit period to pay the amount, it is possible toManagement
construct a ofmultiple
regression model to measure the proportion of amount collected from various
months sales. The model uses cash collection of the month as dependent
variable and previous months sales values as independent variables.

3. Growth in Cash Flow Items: As business grows, the cash flow items also
see a positive growth. Suppose the total sales grow at five percent every
quarter and credit (60 days) sales is eighty percent of the sales. If forty
percent of the customers pay at the end of two months in time, another 40
percent pays at the end of three months and the balance 20 percent pays at
the end of fourth month the amount collected from the customers is also
expected to show an uptrend due to growth in sales.
The most usual approach to cash forecasting is the Receipts and Payments methods
as accepted in Table-6.3. After the firm has determined what types of receipts and
payments are important in its overall cash flow, an important question is how to
forecast the future level of inflows and outflows. There are four common techniques
of forecasting these items of receipt and payment.
a) Direct Method In using this technique, it is assumed that the variable to be
forecast is independent of all other variables, or alternatively, is predetermined.
The variables (e.g.lease rental) is forecast by using its expected or
predetermined level.
b) Proportion of Another Account This technique is used to project financial
variables that are expected to vary directly with the level of another variable. For
example, if sales volume increases, it is natural that more units will have to be
produced to replenish inventory. It is then reasonable to project certain direct
costs of production, such as direct materials, as a per cent of sales.
c) Compounded Growth This method is used when a particular financial
variable is expected to grow at a steady growth rate over time. The formula used
is:
Yt = (1 + g) Y t-1
Where Yt-1 is the prior periods level of y and g is the growth rate.
d) Multiple Dependencies : Under this technique the variable is considered to be
influenced by more than one factor. The statistical technique of linear
regression is often employed with historical data to determine which
explanatory variables are significant in explaining the dependent variable.
We will see the application of regression technique after a while.
Since cash forecasts deal mostly with the near future, many of the items on the cash
forecast are usually estimated by some variation of the spot method. The bases of
these spot estimates are usually the firms other financial plans. Remaining estimates
are mostly on a proportion of another account basis, the another account often being
a particular periods sales. The other two methods are employed less frequently.
It is a common experience that forecast of disbursements is much easier than
receipts, because the cash manager can rely on internal information and knowledge
of payment policy in order to determine what needs to be paid and when. Besides, he
has the knowledge of firms other plans (or budgets) and can make use of the
forecasting techniques described above. However, a major challenge for him comes
in estimating the receipts from the collection of the firms receivables. In this
regard, an useful forecasting method is to analyse the historical payment patterns to
determine the proportion of credit sales that are collected at various times after the
date of sale, and then to use this information (along with the estimates of future sales)
to project future receipts. This has been illustrated in the unit 14 of MS-4 (under the 9

Management
of Current
head
Sales Work
Sheet). We may, however, adopt a better and a more sophisticated
Assets
approach. In this all collection rates are estimated simultaneously by regressing past
sales figures against past collections. The estimated coefficients of the sales figures
in the regression can be interpreted as the collection proportions, and the standard
errors of the estimated regression coefficients as the uncertainty inherent in the
estimation of these collection proportions.

Let us take an example. Suppose that a firm has regressed its monthly collections for
past months against the appropriate past monthly sales figures and has obtained the
following results:
Ct =

0.754 St 1 + 0.241St 2
(0.250) (0.087)

The figures in parentheses below the estimated collection rates are the standard
errors of these collection rates. In this equation, Ct is the collection from receivable in
period t, St 1 is the sales in period t 1 (say, previous month), and St 2 is the sales in
period t-2 (say, two months previously). Assume also that these were the only
statistically significant explanatory variables (the variables like St 3, St 4, etc. and
dummy variables to assess seasonality, were not significant), and that the overall
estimated equation was highly significant. We may now interpret the regression
results in the following way. The estimated collection rates are 75.4 per cent
(regression coefficient on St 1) of the previous months sales and 24.1 per cent
(regression coefficient on St 2) of the sales from two months previously. The implied
bad debt rate is 0.5 per cent, equal to one minus the sum of the collection rates. The
standard error figures are used to test the statistical significance of the estimated
regression coefficients.
Simulation Approach
Simulation analysis permits the financial manager to incorporate in his forecasting
both most likely value of ending cash balances (surplus/deficits) for each of the
forecast periods (say, for each month over the next quarter) and the margin of error
assoicated with this estimate. It involves the following steps: First, probability
distributions for each of the major uncertain variables are developed. The variables
would generally include sales, selling price, proportion of cash and credit sales,
collection rates, production costs, and capital expenditures. Some of these variables
have the greatest influence upon cash balances. Clearly, more time and effort should
be spent in obtaining probability distributions of these variables. Second, values are
drawn at random for the variables from their respective probability distributions, and
using these values each balances are estimated. Third, the process is repeated
several times (say, 100 times). Needless to say, such tedious and cumbersome
computations are done on computer. From the trial results, information of the kind as
shown in table 6.4 would be generated.
Table 6.4 : Hypothetical Simulation Results

10

Month

Average Cash Balance

(Rs. in '000)

Standard Deviation
(Rs. in '000)

April

3,104

334

May

1,258

375

June

-1,221

353

July

-1,104

402

August

-363

403

September

591

421

Management
of Inventory
How can the finance manager use the results of the simulation?
The usefulness
of
the results as shown in Table 6.4 lies in the fact that summary statistics (i.e. average
cash balances and standard deviation) can be used to determine upper/lower
estimates of cash surplus or deflcit for each month, with a probability of say 95
per cent that cash balance will remain within the estimated range. Assuming that the
distribution of month-ending cash balances is normal, we can obtain the upper/lower
estimates by applying the following formula.

Upper/Lower Estimates
= Average Cash Balance + Z Standard Deviation
where Z is the standard normal variate.
With the information of this type in hand, finance manager can now address the
formulation of appropriate investement and financing strategies. Let us now proceed
with some examples to illustrate the point.
Consider our hypothetical simulation results and assume that the costs of having
insufficient cash and the costs of hedges (i.e. financial arrangement to fall back upon
in case of shortage of cash) are such that the firm desires to incur, at maximum, a 5
per cent chance of having insufficient cash to cover expenses. What is the maximum
amount for which the firm should secure a line of credit? The maximum expected
deficit is in the month of June, with a mean of Rs. 12,21,000 and a standard deviation
of Rs. 3,53,000. The Z statistic for 95 per cent confidence interval is 1.645; and 1.645
times of Rs. 3,53,000 is Rs.5,80,685. The maximum amount that the firm should
arrange to borrow is Rs. 12,21,000 plus. Rs. 5,80,685 or Rs. 18,01,685. There is a 5
per cent chance that the actual borrowing needs in June will be greater than this and
a 95 per cent chance that the requirements will be less than this.
Let us now consider that the firm is contemplating how much of the estimated surplus
in September to invest in a 60-day investment. How much can the firm invest and
have only 10 per cent chance of having to resell the investment in September? Z
statistic for 90 per cent confidence interval is 1.28; times of Rs. 4,21,000 is
Rs.5,38,880; Rs. 5,91,000 less Rs. 5,38,880 is Rs.52,120. There is 10 per cent chance
that cash surplus in September will be less than Rs. 52,120. So, the firm can invest
the amount in the 60-days investment and have a 10 per cent chance that they will
have to liquidate the investment prior to maturity.
The above exmaples are intended to illustrate the mechanics of manipulating means,
standard deviations, and probabilites of cash balances rather than to present realistic
hedging strategies. In practice, the array of possible hedging strategies is quite a bit
more complicated. One is required to consider various alternatives and the assoicated
costs and risk in hedging strategies.
Activity 6.4
1) Why do we need to forecast cash flows while managing the cash?
.
.
.
.
.
11

Management
of Current
2)
Collect cash
flow statement given in the annual report of a large listed
Assets
company for the last five years. Comment on the trend in the component.

.
.
..
..
..
3) How does simulation approach help in cash forecasting?
.
.

..
..

6.5 MANAGING UNCERTAINTY IN CASH FLOW

FORECAST
Cash flow forecast is crucial in cash management. Thus, the efficiency of cash
management is directly related to the ability to accurately forecast cash flows.
Unfortunately, two important cash flow variables namely sales and collection
carry a lot of uncertainty and thus affects the cash flow forecast. It is also
difficult to adjust the production and purchasing activity immediately in reaction to
the lower sales and there is always some time lag between decline in sales and
actual adjustment in manufacturing activities. Sales and collection pattern are
affected by several variables and most of them are external factors such as
competition from internal and external market, seasonality, changes in consumers
taste, recession in the market, government policy, etc. Firms have little control on
these variables. Recognising and managing cash flow variation is thus another
important issue in cash management. There are several methods through which
firms recognise and manage the uncertainty associated with cash flow variation.
Sensitivity Analysis: The impact of changes in cash flow variables on cash
balance is examined through sensitivity analysis. The objective of the analysis is
to determine the most sensitive cash flow variables that will place the cash
management in a difficult position. This information is useful to evaluate the
possibility of cash flow variable affected to that extent, plan to ensure that the
cash flow variable is within the normal limit and prepare a contingency plan.
Scenario Analysis: Here cash flows are forecasted under different assumptions
and cash requirement under different scenarios is worked out. Depending on the
level of risk taking capability, firm selects a scenario and uses it for cash
management
Simulation Analysis: It is an extension of scenario analysis. In scenario analysis,
the user defines possible scenarios and the computer generates the cash forecast.
In simulation, the computer is allowed to generate various scenarios based on
random numbers. Since a large number of scenarios are generated, it is possible
12

Management
of Inventory
to define the distribution of cash flow forecast and uncertainty
associated
with
the forecast.This is discussed in more detail in the previous section.

Holding a Stock of Extra Cash or Near-Cash Asset: This is the simplest

solution to manage the uncertainty associated with the forecasting of cash flow.
This is relied upon when the level of uncertainty is high.
Extra Borrowing Capacity: If the uncertainty analysis model helps to figure out
the period in which the firm is likely to face serious problem of cash
management, then it is worth to negotiate with bankers or other financing
agencies well in advance for additional temporary credit. It is possible to have a
standby arrangement with the bank or financial intermediaries.
Using Interest-Rate Derivatives: If uncertainty in cash flows is on account of
expected changes in the interest rate affecting the interest income or interest
payments, the interest-rate derivatives such as interest rates futures and interest
rate options are useful to manage this part of risk.
Activity 6.5
1) Why the actual cash flows show significant variation from the forecast?
.
.
.
.
2) How do you recognise and measure the uncertainty associated with cash flows?
.
.
.
.
3) List down important techniques in managing the uncertain cash flows?
.
.
.
.

6.6 MANAGING SURPLUS CASH

Profit making firms have to generate surplus cash at the end of operating cycle
since the cash collected from debtors is greater than cash invested initially.
However, in reality, many profit making firms see the pressure of negative flow
of cash. There are several reasons for this situation. The mismatch of inflows
and outflows and diversion of short-term funds for long-term needs are two
major reasons for this condition. Though it is not desirable to divert the shortterm funds for long-term needs, often firms resort to this diversion if there is

13

Management
some
delay of
in Current
getting long-term funds. The situation is set right once the firm
Assets
receives the long-term funds. In other words, profit-making firms periodically
generate cash surplus even though they face pressure on cash flows in other
times. The issue is how to deal with such surplus cash. Excess cash balance is
the least productive asset of the firm and thus should be minimised.

Firms normally resort to investing short-term surplus cash in short-term liquid

securities to earn some return. The firm has to decide on two issues at this
juncture. First, it should decide on investment avenues and products. The amount
to be invested is the next important decision.
The investment product is typically short-term, highly liquid government securities.
The Indian money market is not fully developed and generally restricted to banks
and other institutional investors. The investment widely used by the Indian
corporate sector to place short-term capital in Unit-64 scheme of Unit Trust of
India. Earlier, investment in Unit-64 enjoyed certain tax benefit also for the
corporate sector. Since many private sector mutual funds have floated openended debt-based schemes, the demand for this source of investment has
increased in recent times. Certificate of deposits, commercial paper and intercorporate deposits are other popular schemes in which short-term funds are
placed. After liberalisation of the economy, money and capital markets have
become active and the volume and variety in the instruments traded has
increased. The advent of money market mutual funds has broaden the scope for
surplus cash investment.
The amount to be invested depends on transaction cost associated with
investment and period for which the amount is available for investment. Since
the return on short-term securities is generally low, frequent investment and
divestment increases the transaction cost and thus affect the overall return.
Investment optimisation models like Baumol, Miller-Orr and Stone are available to
guide firms to decide on how much to be invested. These models will be
discussed in detail in the next unit.

6.7 MANAGING CASH-IN-TRANSIT

The discussion covered so far generally relates to forecasting of future cash
flows and managing the surplus or deficit cash flows. A related issue of cash
management is improving collection efficiency, particularly speeding up the
conversion of cash-in-transit to cash. The concept is explained with simple
example. Suppose a firm in New Delhi sold Rs.10 lakhs worth of goods to
another firm located in town near Madurai. At the end of credit period, when the
selling firm made an enquiry over phone about the payment, the customer
informed that they have posted the cheque on that day and gave the payment
details. The postal department will take about four to five days to deliver the
post to the seller firm. The seller firm may take about a day or two to process
the receipt and the cheque will be deposited on sixth or seventh day in the bank
account. Since it is outstation cheque, the bank will take about another one to
two weeks to collect the money since the collection bank again has to send the
cheque by post to issuers bank and get the collection details by post. In other
words, it will take about two to three weeks to complete the whole exercise. The
buyer in this process enjoyed another two-three week credit, which is called
''Float'. On a Rs. 10 lakhs, the interest cost for three weeks is around Rs.
10000 (1%). The electronic clearing system that reduces the collection time at
the bank end is not available at all places. The issue is how the selling firm
speeds up the collection process. Though a simple solution is to request the
customer to pay through demand draft and send the draft by speed-post or
courier
after deducting the cost of DD and courier charges, customers may not
14

Management
Inventory
agree to the proposal since they loose the float Thus, we need
to look of
into
our
collection system for improvement.

Selection of Banks with Accelerated Clearing Facilities: An analysis of the

time delay in the collection process, particularly collection of outstation cheques,
shows that a significant part of delay is at banks end. If a firm is having
customers through out the country, then it is necessary to select a bank, which
gives accelerated clearing facilities. Banks may be atleast insisted to process the
clearing through speed post to cut down the delay arising on account of postal
transaction.
Maintaining Accounts in Several Branches: To cut down the time delay in
clearing outstation cheques, the firm can open accounts in important cities, where
the number of clients are more and deposit the cheque in the branches to get
local clearing facility. Funds collected may be electronically transferred to the
head office.
Acceleration of Cheque Processing at the Firm: This is within the control of
the firm. Often, the sales person, who collects the cheque from the customer will
first show the collection to his/her boss before sending the cheque to accounts
department. If the boss is not available or in a meeting, the cheque will be in his
table for a day or two before it moves to accounts department. The person,
who receives the cheque in the accounts department, will first identify the
relevant bill. If there is any shortfall in the value, this will be discussed with the
sales department. After reconciling the cheque amount with the bill, the accounts
department prepares receipt and makes an entry in the cash-book. The cheque
now moves to the person who is preparing challan for depositing into the bank.
If the cheque is deposited beyond certain hours, this will not be taken up for the
days clearing and the cheque has to wait for one more day for collection. All
these activities can be done after noting down the relevant cheque details and
directly handing over the cheque to the employee who is looking after the bank
transaction. It requires simplification of procedure involved in processing of
collection.
Use of Lockboxes: The lockbox is a post office box number to which some or
all the customers would be requested to mail their cheques. The lockbox will be
opened in several cities and the local branches of the bank are authorised to
open the box and clear the cheques. The amount collected under lockbox is
transferred to the notified account. This concept is popular in the US and other
developed countries but not prevalent in India.
Electronic Funds Transfer and Anywhere banking: The advent of banking
technology and the spread of internet facilities has changed the face of corporate
cash management. The more towards paperless economy reduces many of the
difficulties in dealing with cheques/drafts. It should be clear from the prior
discussion that the time necessary for transmittal of cash from one firm to
another revolves largely around the passing from one hand to another of a piece
of paper, ie., the cheque. if we can eliminate this paper there will be a major
saving in the time and cost.
The system of electronic remittances introduced by many foreign and Indian
banks has almost achieved the objective of cheque-less payment mechanisum.
Added to this, the concept of 'Anywhere Banking' practised by many banks also
is helping speedy flow of remittances. with these developments, it should not be
difficult for the firms to eliminats the 'Float. unfortunately, many corporates in
India are not much in favour of the' Electronic Funds Transfer System' mainly
because of their habit of delaying the the payments. It may however, be hoped,
15

Management
of Current
that
the collection
process in the near future will be fully automatic, as far as the
Assets
banking operations are concerned.

Activity 6.6
1) Why is it important to manage the cash-in-transit?
.
.
.

2) What are different options available before the firm in improving collection
efficiency of cash-in-transit?
.
.
.
3) Draw an activity chart that speeds up the process of depositing the cheque in
the bank account from the time of receipt?
.
.
.
4) Outline the impact of internet banking on corporate cash menagement.
.
.
.

6.8 MIS IN CASH MANAGEMENT

The preparation of cash budget based on forecast of cash flows is only the
starting point of cash management. It is the planning part of cash management.
The forecast of cash flows and budget exercises help the management to locate
cash deficient and surplus periods. Managers decide on dealing with the deficit
and surplus, which is decision-making part of cash management. The exercise is
completed, if the control element is also brought into the cash management
system. The control element is required since the operations of the business
enterprise may often deviate from the plan. It is very common that wide
deviation arises between planned and actual cash flows, which keeps the financial
managers always under severe pressure. Often, attention of the managers is
drawn after the problem developed to a full level. Thus, the crucial issue in cash
management is continuous information on actual cash flows and reporting of
deviation. Minor deviation can be tackled by postponing certain discretionary
payments or speedy collection of book debts by offering cash discounts. If the
deviation is expanding, it requires major corrections in the form of negotiating
fresh loan with bankers and improving the collection mechanism. Such corrective
16

Management
of Inventory
actions are possible by developing a good reporting system that
highlights
such
deviations without loss of time.

The daily cash report is the best vehicle for obtaining a running comparison
between the forecast and actual cash flows. Daily cash reporting is useful even
if cash budget and forecast are not available on daily basis. It helps the
managers to understand the flow of cash on daily basis and a comparison of
cumulative figures with the budget indicates the target still to be achieved to keep
the budget in force. In addition, the reporting on daily basis to top management
forces the operating people to work efficiently. This is very useful since
accounting profit cannot be computed on daily basis and available only at the end
of quarter.
Meaningful analysis can be done by consolidating cash flows on daily basis into
two documents namely Cash Flow Budget-Actual Variance Analysis and
Cumulative Cash Flow Statement for the year to date. The formats for the two
reporting documents are given below.
Table 6.5 : Cash Flow Budget-Actual Variance Analysis from .. to .
Cash Flow Item

Budget

Actual

Variance

Remarks

Beginning cash balance

Collection from sales/receivables
Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S&A Expenses
Total
Excess / -Inadequacy
Minimum Balance
Cash Available / -Needed (A)
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan (B)
Closing Cash Balance (A - B)
Table 6.6 : Cumulative Cash Flow Statement For the Year-to -Date

17

Management of Current
Assets

Cash Flow Item

Budget for
the Year

Performance
till Date

Target for
the Remaining
Period

Collection from sales/receivables

Total
Disbursements
Suppliers
Payment of Salaries & Wages
Other Overhead expenses
S&A Expenses
Total
Excess / -Inadequacy
Financing
Borrowing/ -Repayments
Fresh Equity Issue
Sell/ -Acquire Investments
Payment to Fixed Assets
Receive/ -pay interest
Dividend
Total of Financing Plan

A variety of cash reports designed for specific needs of individual companies are
in vogue for checking cash flows and ensuring constant availability of adequate
cash. For example, if the firm has only a few large customers, the top
management would like to have customer-wise cash collection reporting to speed
up the process of collection at the highest level. The information collected from
these statements is useful to fix responsible centres for variance and initiate
corrective steps, which are essential steps in control exercise. The corrective
steps include short-term efforts such as speeding up the collections by chasing a
few large customers and long-term policy changes such as revising credit period
or credit-granting decision.

6.9 SUMMARY
Availability of cash is crucial for the operation of business. However, cash is the
least productive asset of the firm and thus managers take every effort to
minimise the cash holding. Despite the least productive nature of the asset, firms
hold large cash. There are several motives behind holding cash. Cash is required
to settle dues of the firm. Since cash inflows are uncertain and outflows are
certain, firms keep additional cash. Cash kept for these two purposes are called
transaction motive and precautionary motive. Cash is also kept to overcome the
mismatch of inflows and outflows, cyclical behaviour of cash flow pattern and
exploit short-term opportunities, like rising prices and aquisition of control.
Cash flows are affected by internal factors such as operating and financial
policies and external factors such as monetary and fiscal policies and practices of
industry. An understanding on factors that affect the cash flows is useful to
forecast future cash flows, which is core aspect of cash management. There are
several methods of forecasting cash flows and often different methods are
employed
to forecast individual cash flow items. Cash forecasting is converted
18

Inventory
into cash budgets and cash budget is broken into quarterly, Management
monthly andofweekly
cash budgets. Budgets are prepared to understand whether cash inflows and
outflows match with each other and if not, to know the period in which the
mismatch arises. Managers plan to deal with such mismatches by initiating action
in advance.

Despite careful planning, actual cash flows often deviate from the budgets due to
inherent uncertainty associated with cash flow variables. There are several tools
such as sensitivity analysis, simulation, etc., available to evaluate the impact of
uncertainty on cash flows. The uncertainty associated with the cash flows is
managed by holding additional cash, negotiating stand-by borrowing facility and
interest rate derivatives. Management of cash includes dealing with surplus cash
and cash-in-transit. While surplus cash is to be invested in short-term securities
after conducting cost-benefit analysis, cash-in-transit are managed by taking
efforts to reduce the float and float amount.
While planning and decision-making are essential for any management system, the
system completes only when appropriate control mechanism is built into the
system. Management information system assumes importance in this context in
cash management system. Periodical reporting on cash flows and variance
analysis of such flows is essential to effectively manage the cash flows. The
objective of the entire exercise is to ensure availability of cash to conduct smooth
business and at the same time to minimise the investments in this least productive
asset.

6.10 KEY WORDS

Transaction Notice : cash balances required to meet the expenses towards day to
day operations of a business.
Precautionary Motive: Cash balances required to take care of the contingencies
that arise due to unplanned activity.
Speculative Motive: Cash balances kept by a business unit to take advantage of
increasing prices of raw materials, services, etc.
Discretionary Expenses: Expenses that are not directly related to the manufacturing
process, but have some amount of flexibility in timing the expenditure.
Cash Forecast: An estimate of cash inflows and outflows for a specified period.
Simulation Analysis: A method of making forecasts by generating a large number
of probable estimates (generally with the help of a computer) of cash inflows and
outflows and compare the position for their effect on ending balance in a reference
period.
Sensitivity Analysis: A method of studying the impact of changes in cash flow
variables on cash balance.
Float: Refers to cash in transit, which can be utilised by the paying form till it is
actually withdrawn
Electronic Funds Transfer: A mechanism by which receipts payments are handled
through electronic machines.
Cash Budget: A forecast of cash inflows and outflows for a period.
19

Management of Current

Assets
6.11
SELF-ASSESSMENT QUESTIONS

1. Explain the objective of cash management system. How do you deal with
the conflicting nature of the objectives?
2. What are the principal motives of holding cash in a business despite its
unproductive nature?
3. Discuss internal and external determinants that affect the flow of cash.
4. Why is it important to forecast the cash flows in managing the cash?
5. How do you measure the uncertainty associated with cash flows? Discuss
the products available to manage the uncertainty of cash flows?
6. What is flotation? How do you cut down the flotation time?
7. Discuss the importance of cash flow reporting in the management of cash?
8. Digital Electronics Ltd. is preparing cash budget for the next quarter in order
to negotiate with the bankers for additional credit. The sales department
informs that March sales was Rs. 220 lakhs and the expected sales for the
next four months are Rs. 120 lakhs, Rs. 160 lakhs, Rs. 220 lakhs and Rs.
160 lakhs respectively. The company sells 30% of sales through cash and
the balance on credit basis with one month as credit period. The bad debts
level is negligible. Cash outflows consist of payment to creditors, salary and
wages, other operating expenses, purchase of fixed assets and taxes. The
material and labour costs constitute 30% and 45% respectively of the sales.
While raw materials are purchased in one-month credit, wages are paid in
the same month. Other operating expenses cost Rs.50 lakhs and are paid in
the same month. Other non-operating cash flow items are Rs. 150 lakhs in
May (fixed assets), Rs. 120 lakhs in June (fixed assets), Rs. 160 lakhs in
June (corporate tax) Rs. 140 lakhs in April (interest and instalment of loan)
and Rs. 100 lakhs in May (dividend). The cash at the beginning of the
quarter was Rs. 150 lakhs and the companys cash policy is to hold 5% of
total cash expenses of the next month as minimum closing balance of the
current month. Prepare a monthly cash flow statement for the quarter and
highlight the surplus/deficit for each month.
9.

20

Kidcat is a leading manufacturer of toys and sports items for kids. The
industry is facing severe competition from unorganised sector, which imitate
the Kidcat products immediately. The sales of the firm during the last two
years show significant volatility. The firm decides to use simulation this time
while preparing cash budget. The firm has sold Rs. 100 lakhs worth of toys
during the month of March and expects the following possible ranges of sales
between April to June of the next year.
Sales (Rs. in lakhs)

40

80

120

160

Probability

20%

30%

30%

20%

The customers generally pay within a month of sales. The material cost
associated with the product works out to 40%, which are paid after a month
and fixed cost including labour cost of the firm per month is Rs. 30 lakhs.
Fixed costs are paid in the same month. Conduct a simulation exercise of
100 trails using random numbers and find the cash balance at the end of
each month and their distribution. (Hint: Use of Spreadsheet is recommended
to conduct simulation exercise).

Management ofcompany
Inventory
10. The internal analysis of cash flows of a large textile manufacturing
shows a wide variation in cash balances during the next year. The minimum
cash balance expected during the second quarter of the year was -Rs. 340
lakhs (negative balance indicating shortage of cash) and the maximum value
of Rs. 120 lakhs during the month of February. The above figures are
estimates and likely to see significant volatility. The firm presently enjoys over
draft limit of Rs. 300 lakhs and contemplating to increase the limit to Rs. 400
lakhs to meet the additional cash need and also uncertainty associated with
cash flows. The bank is willing to provide the additional loan at 14% interest
rate but insists the firm to accept a commitment charge of 0.25% per month
on the additional borrowing limit. The commitment charge has to be paid on
unused part of the overdraft facility. For instance, if a firm draws Rs. 340
lakhs in August, it has to pay interest at the rate of 14% on Rs. 340 lakhs
and 0.25% on Rs. 60 lakhs. If the firm decides not to accept the offer, it
will be exposed to cash out position and emergency borrowing would cost
2% interest per month. The firm expects a maximum emergency borrowing
of Rs. 200 lakhs at different points of time during the year. Advice the firm
on accepting the additional loan with a commitment charge of 0.25%.

6.12 FURTHER READINGS

Brealey, Richard A and Myers, Stewart C., Principles of Corporate Finance,
Tata-McGraw Hill, New Delhi
Frederick C. Scherr, Modern Working Capital Management: Text and Cases,
Prentice Hall, Englewood Cliffs, NJ.
Joshi, R.N. Cash Management: Perspectives, Principles &Practice, New Age
International (P) Ltd. New Delhi.
Keith V. Smith, Guide to Working Capital Management, McGraw-Hill Book
Company, New York
Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi
Prasanna Chandra, Financial Management, Tata-McGraw Hill, New Delhi
Ramamoorthy, V.E. Working Capital Management, Institute for Financial
Management and Research, Madras.

21