2. 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.
Financial Management, Ninth 2
3. 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
Financial Management, Ninth 3
4. 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.
Financial Management, Ninth 4
5. 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.
Financial Management, Ninth 5
6. 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.
Financial Management, Ninth 6
7. 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.
Financial Management, Ninth 7
8. 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.
Financial Management, Ninth 8
9. 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.
Financial Management, Ninth 9
10. 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.
Financial Management, Ninth 10
11. 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.
Financial Management, Ninth 11
12. 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.
Financial Management, Ninth 12
13. 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.
Financial Management, Ninth 13
14. 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.
Financial Management, Ninth 14
15. Features of Instruments of
Collection in India
Instrument Pros Cons
1.Cheques • No charge •Can bounce
• Payable through clearing •Collection times can be long
• Can be discounted after receipt •Collection charge
• Low discounting charge
• Requires customer limits which are
inter-changeable with overdraft limits
2.Drafts • Payable in local clearing •Cost of collection
• Chances of bouncing are less •Buyers account debited on day one
3.Documentary bills • Low discounting charge •Not payable through clearing.
• Theoretically, goods are not released •High collection cost
till payments are made or the bill is •Long delays
accepted
.
4.Trade bills • No charge except stamp duty •Procedure is relatively cumbersome
• Can be discounted. •Buyers are reluctant to accept the due
• Discipline of payment on due date. date discipline.
5.Letters of credit •Good credit control as goods are •Opening charges
released on payment or acceptance of •Transit period interest
bill. •Negotiation charges
•Seller forced to meet delivery •Need bank lines to open LC.
schedule because of expiry date. • Stamp duty on usance bills
Financial Management, Ninth 15
16. Optimum Cash Balance
Optimum Cash Balance under Certainty:
Baumol’s Model
Optimum Cash Balance under Uncertainty:
The Miller–Orr Model
Financial Management, Ninth 16
17. 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.
Financial Management, Ninth 17
18. 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
Financial Management, Ninth 18
19. 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?
The annual cost will be:
During the year, the company will have to make 100 deposits, i.e. converting marketable securities to cash.
Financial Management, Ninth 19
20. 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).
Financial Management, Ninth 20
21. 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 (σ) 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
Financial Management, Ninth 21
22. Beranek model
Short-term assets such as cash and inventories represent
investments a firm must make in order to support its
operations.
As Beranek [2] notes, companies have short-term assets only
because they face uncertainties related to
their operations.
For example, a firm could incur substantial costs if the labor
force of a vendor supplying a critical
part suddenly went on strike. An inventory of the critical part
enables the firm to continue operating while it seeks
an alternate supplier or waits out the strike. Similarly, a firm may
hold a cash reserve to meet unanticipated demand
for cash. Since cash is an unproductive asset, cash reserves
are often held in the form of highly liquid short-term
investments.
Financial Management, Ninth 22
23. 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
Financial Management, Ninth 23
24. 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.
Financial Management, Ninth 24
25. 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
Financial Management, Ninth 25
