CASH MANAGEMENT

Nature of Cash

Cash is the medium of exchange for

purchase of goods and services and for discharging liabilities. In cash management the term cash has used in two senses.

Narrow sense Broad sense

Narrow Sense:

Under this, cash covers currency

and generally accepted equivalents of cash, viz., cheques , demand drafts .

Broad Sense:

Here, cash includes not only the

above stated but also near cash assets. They are marketable securities. The marketable security can

easily sold and converted into cash.

Why does a firm need cash ?

There are three primary reasons for a firm to hold cash: To meet the needs of daily transactions To protect the firm against uncertainties of its cash flows To take advantage of unexpected investment opportunities

Motive /Objective of holding cash

Transaction motive Precautionary motive Speculative motive

Transaction motive

Transaction motive for holding cash or

near-cash balances is driven by the

need to make planned payments for

items, such as materials, wages, tax,

rent etc.

Precautionary motive
It is driven by the need to protect the firm against being unable to satisfy unexpected demands for cash. For ex-floods, strikes ,slow down in collection of debtors, increase in cost of raw materials etc.

Speculative motive
It refers to the desire of a firm to take advantage of oppertunities. Ex: Purchase of material at reduced price, dealing in commodities in bulk purchasing and selling when rates are considered favourable.

Determinants of cash need

1.Synchronisation of cash flows 2.Short costs. - Cost of transaction - Cost of borrowing -Cost of loss of cash discount -Cost of penalty rates 3.Surplus cash balance cost 4.Management cost

cash planning and control

Management

of cash Cash budgeting. Long term Cash forecasting. Cash reports for control. Investment of surplus funds

Managing cash flow

Accelerating cash collection

Slowing down cash payment

Accelerating cash collection

Prompt

payment of customers Early conversion of payment into cash (Float) Decentralization of collection or concentration banking

Slowing down cash payment

Payment

on last date Centralization of payment

Float
There is a time lag between the time a cheque is prepared by customer and the time the funds are credited to firms account. 1.Postal float-Time taken by the post office in transferring the cheques from the customer to the firm. 2.Lethargy-Time taken in processing the cheques within the company and sending them to bank for deposit.

3.Bank float- Time taken by the bank in collecting the payment from the customers bank. These three collectively known as deposit float.

Cash Management Techniques

Speeding Collections
Concentration Banking
Speeding up collections Slowing down payments

Concentration banking is a collection procedure in which

payments are made to regionally dispersed collection

centers.

Cheques are collected at these centers several times a day

and deposited in local banks for quick clearing.

Cash Management Techniques

Speeding Collections
Lockboxes
A lockbox system is a collection procedure in which payers send their payments to a nearby post office box that is cleared by the firms bank several times a day.

Cash Management Techniques

Speeding Collections
Other Techniques
Wire transfers is a telecommunications book keeping device that removes funds from the payers bank and deposits them into the payees bank thereby reducing collections float. Automated clearing house (ACH) are pre-authorized electronic withdrawals from the payers account that are transferred to the payees account via a settlement among banks by the automated clearinghouse.

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 or cash budget

The

important functions of shortterm cash forecasts

To determine operating cash requirements To anticipate short-term financing To manage investment of surplus cash.

The Receipt and Disbursements Method

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.

Long-term Cash Forecasting

The major uses of the long-term cash forecasts are:

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.

REPORTS FOR CONTROL

Cash reports provide a comparison of actual developments with forecast figures. They are helpful in control and revision of cash forecasts on a continual basis. Among the several types of cash reports, the important ones are: (i) the daily cash report, ii) the daily treasury report, and ii) the monthly cash report.

The daily cash report- it shows the opening balance, receipts, payments and the closing balance in daily basis. The daily treasury report- it provides complete pictures of cash, marketable securities, debentures and creditors. The monthly cash report- It shows the actual receipts and payments in monthly basis.

INVESTMENMT OF SURPLUS FUNDS

Companies often have surplus funds for short period of time, before they are required for capital expenditures, loan repayment, or some other purpose. These funds may be deployed in a variety of ways, like money market instruments, public sector bonds, Short term deposit etc.

Cash Conversion Models

Cash conversion models are used to help

in determining the optimal quantity of

marketable securities to convert into

cash when needed (and vice versa).

Optimum Cash Balance

Optimum Cash Balance under Certainty: Baumols Model Optimum Cash Balance under Uncertainty: The MillerOrr Model

The cash conversion quantity depends on a number of factors, like the fixed cost of transferring funds between cash and marketable securities, the rate of interest, and the firms demand for cash. The objective of these models is to balance the costs and benefits of holding cash or investing in marketable securities.

Baumol Model
The Baumol model is a simple approach

that provides for cost-efficient cash

balances by determining the optimal

cash conversion quantity.

The firm manages its cash by calculating two costs: Conversion cost: the cost of converting marketable securities into cash and vice versa, and Opportunity cost: the cost of holding cash rather than marketable securities

Assumption of Baumol Model

The firm knows its cash needs with certainty. The cash payment of the firm occur uniformly over a period of time and is known with certainty. The opportunities cost of holding cash is known and it remains stable over time. The transaction cost is known and remain stable.

Costs of Holding Cash

Costs of holding cash Trading costs increase when the firm must sell securities to meet cash needs. Total cost of holding cash

Opportunity Costs The investment income foregone when holding cash.

Trading costs C* Size of cash balance

F = The fixed cost of selling securities to raise cash T = The total amount of new cash needed R = The opportunity cost of holding cash C=Economic conversion lot

C C 2 1 2 3 Time

If we start with C, spend at a constant rate each period and replace our cash with C when we run out of cash, our average cash balance C will be . 2 The opportunity cost C C of holding is R 2 2

The Baumol Model

As we transfer C each period we incur a trading cost of F each period.
If we need T in total over the planning T period we will pay F C times. T The trading cost is F Time C

C C 2

The Baumol Model

C T Total cost R F 2 C Opportunity Costs

C R 2
T F C

Trading costs C* Size of cash balance

2T C F R
*

The optimal cash balance is found where the opportunity costs equals the trading costs

The Baumol Model

The optimal cash balance is found where the opportunity costs equals the trading costs. For finding the Economic Conversion Lot
Opportunity Costs = Trading Costs

C T R F 2 C
Multiply both sides by C

T F 2 C2 C 2 R T F R 2 2TF * C R

The management of Ram Co, a small distributor of sporting goods, anticipates Rs.1,500,000 cash demand during the coming year. The firm has determined that it costs Rs.30 to convert marketable securities into cash and vice versa. The marketable securities portfolio currently earns an 8% rate of return. Find the Economic Conversion Lot.

Solution

C=(2x1500000x30)/0.08=Rs33541.02

The Miller-Orr Model

The firm allows its cash balance to move randomly between upper and lower control limits.
$
When the cash balance reaches the upper control limit U, cash is invested elsewhere to get us to the target cash balance Z.

U
When the cash balance reaches the lower control limit, L, investments are sold to Z raise cash to get us up to the target cash L balance.

Time

To use the Miller-Orr model, the manager must do four things:

Set the lower control limit for the cash balance.(L) 2. Estimate the standard deviation of daily cash flows. 3. Determine the interest rate (R). 4. Estimate the trading costs of buying and selling securities (F).
1.