Cash Management

Cash Management
• Cash management is concerned with the
managing of:
– cash flows into and out of the firm,
– cash flows within the firm, and
– cash balances held by the firm at a point of time by
financing deficit or investing surplus cash
Cash management cycle
Cash
Cash is the ready currency to which all liquid assets can be
reduced.
Near Cash
Near cash implies marketable securities viewed the same way
as cash because of their high liquidity.
Marketable Securities
Marketable securities are short-term interest earning money
market instruments used by firms to obtain a return on
temporarily idle funds.
Four Facets of Cash Management
• Cash planning
• Managing the cash flows
• Optimum cash level
• Investing surplus cash
 Motives for Holding Cash
• The transactions motive
• The precautionary motive
• The speculative motive
1. Transaction motive
The transaction motive refers to the holding of cash to
meet anticipated obligations whose time is not perfectly
synchronised with cash receipts.
2. Precautionary motive
• Precautionary motive is a motive for holding
cash/near-cash as a cushion t meet unexpected
contingencies/demand for cash. The unexpected cash
needs at short notice may be the result of:
• Floods, strikes and failure of important customers;
• Bills may be presented for settlement earlier than
expected;
• Unexpected slow down in collection of accounts
receivable;
• Cancellation of some order for goods as the customer
is not satisfied;
• Sharp increase in cost of raw materials.
• The cash balances held in reserve for such
random and unforeseen fluctuations in cash
flows are called as precautionary balances.
• In other words, precautionary motive of
holding cash implies the need to hold cash to
meet unpredictable obligations.
• Thus, precautionary cash balance serves to
provide a cushion to meet unexpected
contingencies.
3. Speculative motive
Speculative motive is a motive for holding cash/near-
cash to quickly take advantage of opportunities typically
outside the normal course of business.

4. Compensating motive
Compensating motive is a motive for holding cash/near-
cash to compensate banks for providing certain services
or loans.
 Objectives of Cash Management

The basic objectives of cash management are two-fold:

(a) to meet the cash disbursement needs
(payment schedule)
(b) to minimise funds committed to cash balances.
Meeting Payments Schedule
A basic objective of cash management is to meet the payment
schedule, that is, to have sufficient cash to meet the cash
disbursement needs of a firm.
The importance of sufficient cash to meet the payment schedule
can hardly be over emphasised. The advantages of adequate cash
are:
1) it prevents insolvency or bankruptcy arising out of the inability
of a firm to meet its obligations;
2) the relationship with the bank is not strained;
3) it helps in fostering good relations with trade creditors and
suppliers of raw materials
4) a cash discount can be availed of if payment is made within the
due date.

For example, a firm is entitled to a 2 per cent discount for a payment made
within 10 days when the entire payment is to be made within 30 days. Since the
net amount is due in 30 days, failure to take the discount means paying an
extra 2 per cent for using the money for an additional 20 days. If a firm were to
pay 2 per cent for every 20-day period over a year, there would be 18 such
periods (360 days ÷ 20 days). This represents an annual interest rate of 36 per
cent;
5) it leads to a strong credit rating which enables the firm to
purchase goods on favourable terms and to maintain its line of
credit with banks and other sources of credit;

6) to take advantage of favourable business opportunities that

may be available periodically; and finally,

7) the firm can meet unanticipated cash expenditure with a

minimum of strain during emergencies, such as strikes, fires or
a new marketing campaign by competitors.
Minimising Funds Committed to Cash Balances

The second objective of cash management is to minimise cash balances. In

minimising the cash balances, two conflicting aspects have to be reconciled. A
high level of cash balances will, as shown above, ensure prompt payment
together with all the advantages. But it also implies that large funds will remain
idle, as cash is a non-earning asset and the firm will have to forego profits. A low
level of cash balances, on the other hand, may mean failure to meet the
payment schedule. The aim of cash management, therefore, should be to have
an optimal amount of cash balances.
 Factors Determining Cash Needs
The factors that determine the required cash balances are:
(1) Synchronisation of cash flows
The need for maintaining cash balances arises from the non-
synchronisation of the inflows and outflows of cash: if the receipts
and payments of cash perfectly coincide or balance each other,
there would be no need for cash balances. The first consideration
in determining the cash need is, therefore, the extent of non-
synchronisation of cash receipts and disbursements. For this
purpose, the inflows and outflows have to be forecast over a
period of time, depending upon the planning horizon which is
typically a one-year period with each of the 12 months being a
subperiod. The technique adopted is a cash budget.
Short Costs
Another general factor to be considered in determining cash needs is the cost
associated with a shortfall in the cash needs. Included in the short costs are the
following:
(1) Transaction costs associated with raising cash to tide over the shortage. This
is usually the brokerage incurred in relation to the sale of some short-term
near-cash assets such as marketable securities.
(2) Borrowing costs associated with borrowing to cover the shortage. These
include items such as interest on loan, commitment charges and other
expenses relating to the loan.
(3) Loss of cash-discount, that is, a substantial loss because of a temporary
shortage of cash.
(4) Cost associated with deterioration of the credit rating which is reflected in
higher bank charges on loans, stoppage of supplies, demands for cash
payment, refusal to sell, loss of image and the attendant decline in sales and
profits.
(5) Penalty rates by banks to meet a shortfall in compensating balances.
Excess Cash Balance Costs
The cost of having excessively large cash balances is known as the
excess cash balance cost. If large funds are idle, the implication is
that the firm has missed opportunities to invest those funds and
has thereby lost interest which it would otherwise have earned.
This loss of interest is primarily the excess cost.

Procurement and Management

These are the costs associated with establishing and operating
cash management staff and activities. They are generally fixed and
are mainly accounted for by salary, storage, handling of securi-ties,
and so on.
Uncertainty and Cash Management
Finally, the impact of uncertainty on cash management strategy is
also relevant as cash flows cannot be predicted with complete
accuracy. The first requirement is a precautionary cushion to cope
with irregularities in cash flows, unexpected delays in collections
and disbursements, defaults and unexpected cash needs.

The impact of uncertainty on cash management can, however, be

mitigated through (i) improved forecasting of tax payments, capital
expenditure, dividends, and so on; and (ii) increased ability to
borrow through overdraft facility.
 Cash Planning

• Cash planning is a technique to plan and

control the use of cash.

• Cash Forecasting and Budgeting

– Cash budget is the most significant device to plan for and
control cash receipts and payments.
– Cash forecasts are needed to prepare cash budgets.
Short-term Cash Forecasts
– The important functions of short-term cash
forecasts
• To determine operating cash requirements
• To anticipate short-term financing
• To manage investment of surplus cash.
– Short-term Forecasting Methods
• The receipt and disbursements method
• The adjusted net income method.
The Receipt and Disbursements Method

• The virtues of the receipt and payment methods are:

It gives a complete picture of all the items of expected
cash flows.
It is a sound tool of managing daily cash operations.
• This method, however, suffers from the following
limitations:
1. Its reliability is reduced because of the uncertainty of
cash forecasts. For example, collections may be delayed,
or unanticipated demands may cause large
disbursements.
2. It fails to highlight the significant movements in the
working capital items.
The Adjusted Net Income Method

• The benefits of the adjusted net income

method are:
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.
• The major limitation of this method is:
It fails to trace cash flows, and therefore, its utility in
controlling daily cash operations is limited.
 Long-term Cash Forecasting

• The major uses of the long-term cash forecasts

are:
 It indicates as company’s future financial needs, especially for
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 future and to formulate
projects carefully.
Managing Cash Collections and
Disbursements
• Accelerating Cash Collections
– Decentralised Collections
– Lock-box System
• Controlling Disbursements
– Disbursement or Payment Float
Features of Instruments of Collection in
India
 Clearing
• The clearing process refers to the exchange by banks of
instruments drawn on them, through a clearinghouse.
• Instruments like cheques, demand drafts, interest and
dividend warrants and refund orders can go through
clearing.
• Documentary bills, or promissory notes do not go
through clearing.
• The clearing process has been highly automated in a
number of countries.
 Controlling Disbursements
• Delaying disbursement results in maximum availability of funds.
However, the firms that delay in making payments may
endanger its credit standing.

• While, for accelerated collections a decentralized collection

procedure may be followed, for a proper control of
disbursements, a centralized system may be advantageous.

• Some firms use 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.
 Optimum Cash Balance
• Optimum Cash Balance under Certainty:
Baumol’s Model
• Optimum Cash Balance under Uncertainty:
The Miller–Orr Model
Baumol’s Model–Assumptions:

• The firm is able to forecast its cash needs

with certainty.
• The firm’s 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.
 Baumol’s Model
• 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
firm’s holding cost for maintaining an average cash balance is
as follows:

Holding cost = k (C / 2)
• 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 = c(T / C )

• The total annual cost of the demand for cash
will be:
Total cost = k (C / 2)  c(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:
2cT
C *
k
Baumol's model for cash balance Cost trade-off: Baumol's model
 The Miller–Orr Model
• The MO model provides for two control limits–the upper
control limit and the lower control limit as well as a return
point.
• If the firm’s 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 firm’s 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).
Miller-Orr model
 The Miller-Orr Model
• The difference between the upper limit and
the lower limit depends on the following
factors:
– the transaction cost (c)
– the interest rate, (i)
– the standard deviation (s) of net cash flows.
• The formula for determining the distance between
upper and lower control limits (called Z) is as follows:
(Upper Limit – Lower Limit) = (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate)1/ 3

Upper Limit = Lower Limit + 3Z

Return Point = Lower Limit + Z
The net effect is that the firms hold the average the cash balance equal to:
Average Cash Balance = Lower Limit + 4/3Z
INVESTING SURPLUS CASH IN MARKETABLE
SECURITIES

• Selecting Investment Opportunities:

– Safety,
– Maturity, and
– Marketability.
Short-term Investment Opportunities:

– Treasury bills
– Commercial papers
– Certificates of deposits
– Bank deposits
– Inter-corporate deposits
– Money market mutual funds