56621791 cash-manageemnt

Unit - 7

Cash Management

2Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Chapter Objectives

Explain the reasons for holding cash: Underline the need for cash management. Discuss the techniques of preparing cash

budget. Focus on the management of cash collection

and disbursement. Emphasise the need for investing surplus

cash in marketable securities.


Cash Management Cash is the basic input needed to keep the business

running on a continuous basis; it is also the ultimate output expected to be realised by selling the service or product manufactured by a firm.

Cash is the money which a firm can disburse immediately without any restriction. It includes coins, currency & cheques held by a firm, balances in bank A/cs, sometimes near cash items like marketable securities may also be included.

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


Four Facets of Cash Management Cash planning – Cash inflows & outflows should be

planned to project cash surplus or deficit for each planning period. Cash budget maybe used for this purpose.

Managing the cash flows – Cash flows should be properly managed , cash inflows-accelerated, cash outflow-decelerated.

Optimum cash level- firms decision, Cost of excess cash & danger of cash deficiency should be matched to determine optimum cash levels.

Investing surplus cash- to earn profits, firm should decide

between alternative short term investment opportunities such as bank deposits, marketable securities or inter corporate lending.


Motives for Holding Cash The transactions motive – requires a firm to hold cash to conduct

its business in ordinary course. No need to hold cash if there were perfect synchronisation between cash receipts & cash payments i.e enough cash is received when payment has to be made.

For periods when cash payments exceed cash receipts , firm should maintain cash balance. Firms may invest cash in marketable securities. Usually firms invest in securities whose maturity corresponds with some anticipated payments, such as dividends or taxes in the future.

The precautionary motive -Hold cash to meet contingencies in future, amount of cash depends upon the predictability of cash flows, also influenced by firms ability to borrow at short notice. Such funds should be invested in high liquid , low risk marketable securities.

The speculative motive- holding cash for investing in profit making opportunities as & when they arise.


Cash Planning Cash planning is a technique to plan and control

the use of cash. Helps to anticipate future cash flows& needs of firm & reduces possibilities of ideal cash balances &cash deficits .

Large firms- daily& weekly forecasts, Medium size firms- weekly &monthly forecasts, Small firms- monthly basis.

Cash Forecasting and Budgeting Cash budget is the most significant device to plan for

and control cash receipts and payments. It is a summary statement of firms cash flows over a

projected time period. 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 (see numerical on pg 644) 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:Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be delayed, or unanticipated demands may cause large disbursements.It fails to highlight the significant movements in the working capital items.


The Adjusted Net Income Method It involves tracing of working capital flows,also called

sources &uses approach. Two objectives of this method , To project company’s need for cash at a future date. To show whether a company can generate required funds

internally, & if not how much will have to be borrowed /raised form capital market.

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 When a firm receives /makes payments in the form of cheques

etc, there is usually a time gap between the time the cheque is written & when it cleared, this time gap is know a float.

For paying firm- time elapsed between issue of cheque & time when funds underlying the cheque are actually debited in bank A/c.

For Payee firm- time between receipt of cheque &availability of funds in its account.

Types- Payment float – cheque issued but not presented for payment . Receipt float- amount of cheque deposited but not yet cleared . Net float-difference between payment float & receipt float.


Decentralised Collections Called concentration banking in USA, system of

operating through a number of collection centres, instead of a single collection centre centralized at a firms head office.

Basic purpose to minimize the lag between the mailing time from customers to firm & time when the firm can use the funds.

The collection centre will transfer funds above some predetermined minimum to a central/concentration bank a/c, generally at the firms head office each day.

A concentration bank is one in which the firm has a major a/c usually a disbursement a/c.


Lock box system Firm establishes a number of collection centres

considering customer locations& volume of remittances.

At each centre the firm hires a post office box & instructs its customers to mail their remittances to the box .

The firms 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 & deposits the cheques in firms a/c.

Advantage- bank handles remittance prior to deposit at lower cost.


Controlling Disbursements Effective control of disbursement helps a firm in conserving

cash& reducing financial requirements.

Disbursements arise due to trade credit. Delaying disbursements results in maximum availability of

funds. However firms that delay in making payments may endanger its credit standing.

For proper payment of disbursements, a centralized system maybe advantageous, payments will be made from a central a/c. for local payee, who are far from the central a/c the transit time will increase & firm will gain by this delay.


Features of Instruments of Collection in IndiaInstrument Pros Cons

1.Cheques No charge Payable through clearing Can be discounted after receipt Low discounting charge Requires customer limits which are inter-changeable with overdraft limits

Can bounce Collection times can be long Collection charge

2.Drafts Payable in local clearing

Chances of bouncing are less Cost of collection Buyers account debited on day one

3.Documentary bills Low discounting charge

Theoretically, goods are not released till payments are made or the bill is accepted

Not payable through clearing.High collection cost Long delays

. 4.Trade bills No charge except stamp duty

Can be discounted.Discipline of payment on due date.

Procedure is relatively cumbersome Buyers are reluctant to accept the due date discipline.

5.Letters of credit Good credit control as goods are

released on payment or acceptance of bill.Seller forced to meet delivery schedule because of expiry date.

Opening charges Transit period interest Negotiation charges Need bank lines to open LC. Stamp duty on usance bills


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:

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:

The total annual cost of the demand for cash will be:

The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for the optimum cash balance is as follows:

Holding cost = ( / 2)k C

Transaction cost = ( / )c T C

* 2cTC

k

Total cost = ( / 2) ( / )k C c T C


Illustration–Baumol’s Model

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

k/cT2C*

000,200Rs15.0

)000,000,20)(150(2C*

The annual cost will be:

30,000 Rs=15,000+15,000=(1,00,000)0.15+(100)150=2)(2,00,000/0.15+2,00,000)(2,00,000/150=cost Total

During the year, the company will have to make 100 deposits, i.e. converting marketable securities to cash.


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).


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 () of net cash flows.

The formula for determining the distance between upper and lower control limits (called Z) is as follows:

1/ 3(Upper Limit – Lower Limit) = (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate) Upper Limit = Lower Limit + 3

Return Point = Lower Limit +

The net effect is that the firms hold the average the cash balance equal to:

Average C

Z

Z

ash Balance = Lower Limit + 4/3Z


Beranek model Short-term assets such as cash and inventories represent

investments a firm must make in order to support itsoperations. As Beranek [2] notes, companies have short-term assets only because they face uncertainties related totheir operations. For example, a firm could incur substantial costs if the labor force of a vendor supplying a criticalpart suddenly went on strike. An inventory of the critical part enables the firm to continue operating while it seeksan alternate supplier or waits out the strike. Similarly, a firm may hold a cash reserve to meet unanticipated demandfor cash. Since cash is an unproductive asset, cash reserves are often held in the form of highly liquid short-terminvestments.


Investing Surplus Cash in Marketable Securities Selecting Investment Opportunities:

Safety- probability of getting back the amount invested.

Firm should invest in high yielding marketable securities having an acceptable level of risk i.e default risk.

Maturity – time period over which interest & principal are to be made.

Long term security fluctuates more rapidly with the interest rate changes than the price of short term security.

Marketability- refers to the convenience & speed with which a security/ investment can be converted into cash.

Important aspects price & time


Short-term Investment Opportunities: Fixed Deposits with banks.

Treasury bills (TB’s) – represent short term obligations of the government which have maturities like 91 days, 182 days & 364 days.

Commercial papers (CP’s)

Certificates of deposits (CD’s) – certificates issued by banks acknowledging fixed deposits for a specified period of time

Inter-corporate deposits – popular short term investment alternative for companies in India. Generally a cash surplus company will deposit (lend) its funds in a sister /associate company or with outside companies with high credit standing.

Lending is for very short periods, risk of default is high, but returns are attractive.

Money market mutual funds (MMMF’s)- focus on short term marketable securities like TB’s, CP’s. CD’s. Minimum lock in period of 30 days.

offer attractive yields usually 2% more than bank deposits of same maturity.


Strategies for managing surplus funds Do nothing- the financial manager simply allows surplus liquidity to accumulate in the

current account. this strategy enhances liquidity at the expense of profits that could be earned from investing surplus funds.

Make Adhoc investments.

Ride the yield curve- Increase the yield from a portfolio of marketable securities by betting on the interest rate changes.

Develop guidelines - reflect the view of management towards risk &return. E.g. (i) Do not speculate on interest rate charges. (ii) hold marketable securities till they mature.

Utilize Control limits- Based on the premise that cash mgt models define upper & lower control limits .

upper limit- invest in marketable securities. lower limit- liquidate some securities to augment cash resources of firm. Manage with a portfolio perspective.

Follow a mechanical procedure- the financial manager may switch fund between cash account & marketable securities


Thank You.Thank You.

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56621791 cash-manageemnt