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Cash Management

  1. Cash management DR. MOHAMED KUTTY KAKKAKUNNAN Associate Professor P.G. Dept. of Commerce N A M College Kallikkandy Kannur – Kerala - India
  2. CASH MANAGEMENT • An important current asset • It is the input needed to carry on the business continuously and the output realized by selling the goods or services • It is the money which can be disbursed without any restrictions and include currency, coins, cheques and bank balance • Least profitable but most liquid asset • Thus, surplus cash will be invested in marketable securities i.e near cash items
  3. What is CASH MANAGEMENT? managing of (a) cash flows into and out of the firm, (b) cash flows with in the firm, and (c) cash balances held by the firm at a point of time by financing deficit or investing surplus cash Has to consider Liquidity and profitability at the same time control over cash flows and balance
  4. The strategy of cash management involves – • Cash planning - • Managing flows of cash – • Determining and maintaining • Investing surplus cash Motives for holding cash • Transaction motive (to conduct transactions) • Precautionary motive (to meet contingencies) • Speculative motive (to capitalize profitable opportunities immediate cash may be required)
  5. Cash Planning • Forecasting inflows and outflows of cash, determining the surplus or deficit of cash during a given period of time • A technique to plan and control of the use of cash • Can be done on daily, weekly, monthly basis and depends upon the size of the firm • Cash forecasting and cash budgeting Cash budget
  6. Determining Optimum Cash Balance - Liquidity vs. Profitability - Transaction motive, precautionary motive and speculative motive Has to determine optimum cash balance Optimum Cash Balance Under Certainty (Baumol’s Model) • A model for determining optimum cash balance under certainty • The considers cash management similar to inventory management • According to him, management tries to minimize the various costs related with maintaining cash balance
  7. There are two costs with cash • Cost of holding cash (inventory of cash) and • The cost of converting marketable securities to cash Holding cost is the cost of keeping the cash balance It is the opportunity cost – the return forgone on marketable securities for maintaining cash without investing If the opportunity cost is k, the cost of maintaining (holding) average cash balance will be Holding cost = k(C/2) where C average cash balance
  8. Transaction cost is the cost incurred for converting marketable securities into cash Depends upon total number of transactions (T), Cash Balance (C) and cost per transaction (c), which remains constant Transaction Cost = c(T/C) Thus, Total Cost = k(C/2) + c(T/C) Optimum cash balance reduces both costs to the minimum and is found out through trade off between holding cost and transaction costs C=
  9. Assumptions • The firm is able to forecast its cash needs with certainty • Cash payment occur uniformly during the period • Opportunity cost of holding cash is known and it is constant • Incur transaction costs whenever, it converts securities into cash
  10. Optimum Cash Balance Under Uncertainty – The Miller –Orr Model Major limitation of Baumol Model is that, the model assumes cash flow and balance to be even (do not fluctuate) and firm is able to predict daily cash inflows and outflows. But it is not possible. This limitation is overcome by Miller-Orr model According to them, net cash flows are normally distributed with a zero value of mean and a standard deviation. The model has two control limits – upper control limit and lower control limit as well as a return point. If the firms cash balance fluctuate and hit the upper limit it will purchase securities to return to the normal position and when the cash balance hits the lower limit, it will dispose securities to have sufficient cash balance.
  11. The firm sets upper and lower limits of maintaining cash balance after considering the transaction costs (c), interest rates (i) and the standard deviation of (σ) net cash flows The lower limit is set by the management after considering the liquidity requirements Other limits (upper limits and the control limit (Z)) (also known as distance) are set by using the following formula First set control limit (z) z = (¾ X transaction cost x Cash flow variance / interest per day)1/3
  12. RP= Where RP = Return point b = Fixed cost per order for converting marketable securities into cash = Variance Daily Changes Expected In Cash Balance i= Daily interest rate earned on the securities LL = Lower Limit UL = 3RP – 2LL UL = Upper limit