Chapter - 30: Cash Management

Chapter - 30
Cash Management
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.
BY Akash Saxena
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
BY Akash Saxena
Four Facets of Cash Management
 Cash planning
 Managing the cash flows
 Optimum cash level
 Investing surplus cash
BY Akash Saxena
Motives for Holding Cash
 The transactions motive
 The precautionary motive
 The speculative motive
BY Akash Saxena
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.
BY Akash Saxena
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.
BY Akash Saxena
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:
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.
BY Akash Saxena
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.
BY Akash Saxena
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.
BY Akash Saxena
Managing Cash Collections and
Disbursements
 Accelerating Cash Collections
 Decentralised Collections
 Lock-box System
 Controlling Disbursements
 Disbursement or Payment Float
BY Akash Saxena
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
BY Akash Saxena
Optimum Cash Balance
 Optimum Cash Balance under Certainty:
Baumol’s Model
 Optimum Cash Balance under
Uncertainty: The Miller–Orr Model
BY Akash Saxena
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.
BY Akash Saxena
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
BY Akash Saxena
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?
C*  2cT / k
* 2(150)( 20,000,000)
C   Rs200,000
0.15
The annual cost will be:
Total cost = 150(2,00,000/2,00,000) + 0.15(2,00,000/2)
= 150(100) + 0.15(1,00,000) = 15,000 + 15,000 = Rs 30,000
During the year, the company will have to make 100 deposits, i.e. converting marketable securities to
cash.
BY Akash Saxena
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).
BY Akash Saxena
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:
(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
BY Akash Saxena
Investing Surplus Cash in
Marketable Securities
 Selecting Investment Opportunities:
 safety,
 Maturity, and
 marketability.
BY Akash Saxena
Short-term Investment Opportunities:
 Treasury bills
 Commercial papers
 Certificates of deposits
 Bank deposits
 Inter-corporate deposits
 Money market mutual funds
BY Akash Saxena

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Chapter - 30

2.Drafts Payable in local clearing Cost of collection

3.Documentary bills Low discounting charge Not payable through clearing.

5.Letters of credit Good credit control as goods are Opening charges

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