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Cash Management: Prof S N Rao 1
Cash Management: Prof S N Rao 1
Cash Management: Prof S N Rao 1
Prof S N Rao 1
Key Concepts & Skills
• Understand the importance of Cash Budget
• Be able to prepare Cash Budget
• Understand factors for efficient cash management
• Understand models useful for determining optimum cash balance
• Understand factors considered for investment of surplus cash
• Understand the factors determining the choice of liquidity mix
Prof S N Rao 2
Cash Budget
Helpful in
• Estimating cash requirements/surplus
• Planning short‐term financing/investments
• Scheduling payments in connection with capital expenditure projects
• Planning purchases of materials
• Developing credit policies
Prof S N Rao 3
Cash Budget
Receipt item Basis of Estimation
Cash sales Est.sales and its division
between cash and cr. sales
Collection of A/R Credit policy
Int. and div. receipts Firm’s portfolio of sec.
Increase in loans, Firms financing plan
deposits, and issue of
new securities
Sale of assets Proposed disposal of assets
Prof S N Rao 4
Cash Budget
Prof S N Rao 5
Example: Cash Budget
• ABC Ltd all income from sales
• Sales estimates (in Rs. Crs)
• Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550
• Accounts receivable
• Beginning receivables = 250
• Average collection period = 30 days
• Accounts payable
• Purchases = 50% of next quarter’s sales
• Beginning payables = 125
• Accounts payable period is 45 days
• Other expenses
• Wages, taxes, and other expense are 30% of sales
• Interest and dividend payments are 50
• A major capital expenditure of 200 is expected in the second quarter
• The initial cash balance is 80, and the company maintains a minimum balance of 50
Prof S N Rao 6
Example: Cash Budget – Cash Collections
• ACP = 30 days; this implies that 2/3 of sales are collected in the
quarter made and the remaining 1/3 are collected the following
quarter
• Beginning receivables of 250 will be collected in the first quarter
Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
7
Prof S N Rao
Example: Cash Budget – Cash Disbursements
• Payables period is 45 days, so half of the purchases will be paid for
each quarter and the remaining will be paid the following quarter
• Beginning payables = 125
Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other 150 180 195 240
expenses
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628
8
Prof S N Rao
Example: Cash Budget – Net Cash Flow and Cash Balance
Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 138 -38 -12 110
Prof S N Rao 9
Factors for Efficient Cash Management
• Prompt billing
• Expeditious collection of cheques
• Centralized purchases and payments to suppliers
• Playing float
Prof S N Rao 10
Playing Float
• ABC Ltd issues cheques of Rs.20000 daily and it takes 6 days for these
cheques to cleared
• ABC Ltd receives cheques of Rs.20000 daily and it takes 4 days for
these cheques to be realised
• There is zero balance in the books of the firm and the books of the
bank
Prof S N Rao 11
Playing Float
Day 1 2 3 4 5 6 7 8
Balance in 0 0 0 0 0 0 0 0
Books of Co
Balance in 0 0 0 0 +20K +40K +40k +40K
Books of
Bank
Net Float 0 0 0 0 +20K +40K +40k +40K
Bk Bal –
Book Bal
Prof S N Rao 12
Optimum Cash Balance: Costs of Holding Cash
Trading costs increase when the firm
must sell securities to meet cash needs.
Trading costs
C* Size of cash balance
Prof S N Rao 13
The BAT Model (Boumol‐Allais‐Tobin Model)
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, i.e., the
interest rate
If we start with Rs.C, spend at
a constant rate each period
and replace our cash with
C Rs.C when we run out of
cash, our average cash
balance will be – C
–C2 2
The opportunity cost
of holding – C is C ×R
2
–2
Time
1 2 3 Prof S N Rao 14
The BAT Model
As we transfer Rs.C
each period we incur a
trading cost of F.
If we need Rs. T in
C total over the planning
period we will pay Rs.
F times T/C
–C2
Prof S N Rao 15
The BAT Model
C T
Total cost R F
2 C
C
Opportunity R
Costs
2
T
Trading costs F
C
C* Size of cash balance
2T
C* F Prof S N Rao 16
R
The BAT Model
The optimal cash balance is found where the
opportunity costs equals the trading costs.
C T
R F
2 C
Multiply both sides by C
C2 T F
R T F C 2
2
2 2TF R
C*
Prof S N Rao
R 17
The BAT Model
Assumptions
• It is possible to forecast cash requirements with certainty
• Cash payments occur uniformly over the period
• Opportunity cost of holding cash is known and it does not change over the
period
Prof S N Rao 18
The BAT Model
Given:
• Planning period: 3 months
• Yield on marketable securities: 12% p.a.
• Cash required during planning period: Rs.15 lakhs
• Cash conversion cost: Rs.500 per transaction
Required:
Compute optimum cash balance
Prof S N Rao 19
The Miller‐Orr Model
• The firm allows its cash balance to wander
randomly between upper and lower control
limits.
Rs. When the cash balance reaches the upper control limit U, cash
is invested elsewhere to get us to the target cash balance .
U
When the cash balance
reaches the lower
control limit, L,
investments are sold to
C* raise cash to get us up
to the target cash
L balance.
Prof S N Rao 20
Time
The Miller‐Orr Model
• Given L, which is set by the firm, the Miller‐Orr
model solves for C* and U
3 Fσ 2
U *
3C *
2L
C
* 3 L
4R
where 2 is the variance of net cash flows per
period
• The average cash balance in the Miller-Orr model
is: 4C * L
Average cash balance
3
Prof S N Rao 21
The Miller‐Orr Model
• To use the Miller‐Orr model, the
manager must do four things:
1. Set the lower control limit for the cash
balance.
2. Estimate the standard deviation of daily cash
flows.
3. Determine the interest rate.
4. Estimate the trading costs of buying and
selling securities.
Prof S N Rao 22
The Miller‐Orr Model
• The model clarifies the issues of cash
management:
• The optimal cash position, C*, is positively
related to trading costs, F, and negatively
related to the interest rate R.
• C* and the average cash balance are
positively related to the variability of cash
flows.
Prof S N Rao 23
The Miller‐Orr Model
Given:
LL: Rs.50000
Transaction cost: Rs.500
Yield on marketable securities: 12% p.a.
Variance of cash balance: 5000
Required:
Compute optimum cash balance and upper limt
Prof S N Rao 24
Investing Surplus Cash
Two basic problems
1.Determination of surplus cash
• During normal period
• During peak period
Surplus cash = actual cash ‐ Min cash req.
2.Determination of channels of investment
• Criteria for investment:
• Security
• Liquidity
• Yield/Return
• Maturity
Prof S N Rao 25
Investing Surplus Cash
Purpose of holding Criteria for
surplus cash investment
To meet un-foreseen Safety and liquidity
payments
To make available on Safety and
certain definite dates maturity
General reserves not Safety and yield
required to meet any
specific payments
Prof S N Rao 26
Forms of Liquidity
• Cash balance (4% ‐5% of CAs)
• Cash credit arrangement
• Benefits: lesser after tax cost
• Disadvantages: imposition of penal interest on
under/over utilization and close scrutiny of budgets of
the company by banks
• Marketable securities
• T Bills,Govt Bonds,CPs,ICDs, CDs, Bill Disc,other Capital
market securities
Prof S N Rao 27
Choice of Liquidity Mix
Depends on
• Uncertainty surrounding the cash flow projections
• Attitude of the management towards risk
• Ability to raise non‐bank funds
• Ability to control its cash flows
Prof S N Rao 28
Case‐4: Khanna Mfg Co.
• Compute Cash Receipts
• Compute Cash Payments
• Compute cumulative cash balance
• Suggest alternatives for arranging the cash during the months of
shortfall
Prof S N Rao 29
Credit Management
Prof S N Rao 30
Credit Policy Variables
• Credit standards
• Credit period
• Cash discount
• Collection effort
Prof S N Rao 31
Credit Policy Variables
• Credit standards
• What standard should be applied in accepting or rejecting an account for granting credit?
• Not to extend credit to any customer
• Extend credit to every customer
• Actual credit standards lie between the two extreme positions
• Liberal credit standards
• Push up sales
• Lead to higher bad debt loss
• Higher collection cost
• Requires more investment in receivables
• Stiff credit standards have the opposite effects
• Change in credit standard has impact on profit
Prof S N Rao 32
Credit Policy Variables
• Credit period
• Varies from 15‐60 days
• Stated as ‘net 30’ or ‘net 60’…
• Lengthening of credit period
• Pushes up sales
• Results in higher investment in debtors
• Leads to higher bad debt loss
• Shortening of credit period has opposite impact
• Change in credit period has impact on profit
Prof S N Rao 33
Credit Policy Variables
• Cash discount
• Offered to induce customers to make prompt payments
• The discount percentage and discount period is reflected in credit terms
• Example: ‘2/10, net 45’
• Liberalizing cash discount policy may mean higher discount percent and/or longer discount
period
• Results into
• Higher sales
• Lower average collection period
• Lower investment in debtors
• Higher cost of discount
• Tightening cash discount policy will have opposite effect
• Change in discount policy has impact on profit
Prof S N Rao 34
Credit Policy Variables
• Collection effort
• Monitoring the state of receivables
• Dispatch of letters to customers whose due date is approaching
• Electronic and telephonic advice to customers around the due date
• Threat of legal action to overdue accounts
• Legal action against overdue accounts
• Relaxing collection efforts
• tends to increase sales
• lengthen average collection period
• increase bad debt loss
• decrease collection cost
• Rigorous collection effort will have opposite effect
• Change in collection effort has impact on profit
Prof S N Rao 35
Credit Evaluation
• Assessment of credit risk
• Helps in establishing credit limits
• Errors
• Type‐I error: a low risk customer is misclassified as a high risk customer
• Type‐II error: a high risk customer is misclassified as a low risk customer
Prof S N Rao 36
Credit Evaluation
• Traditional Credit Evaluation
• Assessment of prospective customer in terms of
• Character: willingness to honor obligations
• Capacity: ability to meet obligations from OCFs
• Capital: availability of capital for meeting obligations in case OCFs are not sufficient
• Collateral: security offered by the customer in the form of pledged assets
• Conditions: the general conditions that affect the customer’s ability to meet obligations
• Sources of information
• Financial statements
• Bank reference
• Experience of the firm
• Stock market performance of customer firm
Prof S N Rao 37
Credit Evaluation
• Numerical Credit Scoring
• Identify factors relevant for credit evaluation
• Assign weights to these factors that reflect their relative importance
• Rate the customer on various factors using suitable rating scale
• Convert factor into factor score
• Add all the factor scores to get the overall customer rating index
• Based on the rating index, classify the customer
Prof S N Rao 38
Credit Evaluation
Construction of Credit Rating Index
(based on a 5 point rating scale)
Factor Factor weight Rating Factor Score
Prof S N Rao 41
Credit Granting Decision
• Compute expected profit of offering credit without repeat order and
with repeat order
• If it is positive, offer credit
Prof S N Rao 42
Monitoring & Control of Credit‐
Day’s Sales Outstanding (DSO)
0-30 35
31-60 40
61-90 20
>90 5
Prof S N Rao 44
Limitations of DSO & AS
• Influenced by sales pattern
• Payment behavior of customers
• If sales are increasing/decreasing DSO and the AS will defer from
what they would be if sales are constant
• This holds even when payment behavior of the customer remain
unchanged
Prof S N Rao 45
Collection Matrix/Payment Pattern
Prof S N Rao 46
Credit Management in India
Credit Policy
• No formalization of credit policy
• Too general statement of policy
• Credit period: 0‐90 days
• Cash discount for prompt payments is not common
Prof S N Rao 47
Credit Management in India
Credit Analysis
• No detailed analysis of financial statements
• Customers are required to furnish 2‐3 references
• Independent agencies for credit rating are coming up
• Credit information from bank is too general
• Large companies classify customers based on credit
worthiness
Prof S N Rao 48
Credit Management in India
Control of Receivables
• No systematic methods for controlling and monitoring receivables
• Normal measures of credit management
• Bad debt losses
• Average collection period
• Aging schedule
Prof S N Rao 49
Inventory Management
Prof S N Rao 50
Inventory Management
• Types of Inventory
• EOQ Model
• Order point
• Pricing Raw Material
• Valuation of Stock
• Monitoring and Control of Inventory
Prof S N Rao 51
Types of Inventory
• Process inventory
• Movement inventory
• Organization inventory
Prof S N Rao 52
Objectives of Inventory Management
• To maintain a large size of inventories of raw material and work‐in‐
process for efficient and smooth production and of finished goods for
uninterrupted sales operations.
Prof S N Rao 53
An effective inventory management should..
• ensure a continuous supply of raw materials, to facilitate
uninterrupted production
• maintain sufficient stocks of raw materials in periods of short supply
and anticipate price changes
• maintain sufficient finished goods inventory for smooth sales
operation, and efficient customer service.
• minimize the carrying cost and time, and
• control investment in inventories and keep it at an optimum level.
Prof S N Rao 54
Inventory Management Techniques
• Economic order quantity (EOQ)
• ordering costs: requisitioning, order placing, transportation, receiving,
inspecting and storing, administration
• carrying costs: warehousing, handling, clerical and staff, insurance,
depreciation and obsolescence
• ordering and carrying costs trade‐off:
Prof S N Rao 55
EOQ Model
Assumptions
• Usage is known
• Even usage
• Immediate replenishment
• Only two costs: ordering and carrying
• Ordering cost is constant
• Carrying cost is fixed % of the avg inventory
Prof S N Rao 56
Ordering Point
• If lead time and usage are stable:
Ordering point
= lead time for procurement X Average daily usage
• If lead time and usage are volatile
Ordering point
= ( Avg lead time for procurement X Average daily usage) +
Safety stock
Prof S N Rao 57
Factors Influencing level of inventory
Prof S N Rao 58
Factors influencing inventory
• Anticipated scarcity
• Expected price change
• Obsolescence risk
• Govt restrictions
• Marketing considerations
Prof S N Rao 59
Pricing of Raw Material
• FIFO Method
• WA Cost Method
Prof S N Rao 60
Valuation of FG Inventory
• Direct/Variable Costing
• Fixed Mfg exp are treated as period cost
• Value of WIP&FG is lower under this method
• Absorption/Total Costing
• Fixed Mfg exp are treated as product cost
• Value of WIP & FG is higher under this method
Prof S N Rao 61
Monitoring and Control of Inventory
• ABC Analysis
• Ratio Analysis
• JIT
Prof S N Rao 62
Inventory Management in India
Inventory levels in India are high due to
• Sever penalty for stock out and no penalty for excess
inventory
• Lengthy and cumbersome import process
• High inflation
• Lack of standardization
• Long lead time
Prof S N Rao 63
Inventory Management in India
Common tools of Inventory Mgt
• FSN Analysis
• Inventory turn over ratios
• ABC Analysis
Prof S N Rao 64
Sources of Working Capital
Prof S N Rao 65
Sources of WC Finance
• Accruals
• Trade credits
• WC advance from Banks
• Public deposits
• ICDs
• Rights Debentures
• CPs
• Factoring
Prof S N Rao 66
Accruals
• Wages &Taxes
• Cost free sources
• Not amenable to control by Mgt
Prof S N Rao 67
Trade Credit
• Represents the credit extended by the supplier of goods and services
• Spontaneous source of finance
• Constitutes 25%‐50% of WC finance
• Is it cost free?
Prof S N Rao 68
Bank Finance
• Cash Credit/Over Draft
• Loans
• Purchase/Discount of Bills
• Letter of Credits
• Security
• Hypothecation
• Pledge
• Margin
• Cost?
Prof S N Rao 69
Public Deposits
• Can not exceed 25% of NW
• Need to create Deposit
Redemption Reserve (DRR)
• Disclosure of financial performance
• Cost?
Prof S N Rao 70
Public Deposit Schemes of Tata Motors
Scheme‐A: Scheme‐B
Quarterly Income Plan Cumulative Deposit Plan
Period Min Amt Int Rate Period Min Int Rate Maturity Implied
(p.a) Amt (p.a.) value yield
1 year 20000 10% 1 year 20000 10% 22 076 10.36%
2 years 20000 10.5% 2 years 20000 10.5% 24 607 10.92%
3 years 20000 11% 3 years 20000 11% 27 696 11.46%
0.5% additional interest for senior citizens/shareholders/employees
The issue was floated in Nov 2009
Prof S N Rao 71
Public Deposit Schemes of Bajaj Fin Ltd
Scheme‐A: Scheme‐B
Cumulative Income Plan
Period Min Amt Int Rate Period Monthly Quarterly Half Yearly Annual
(p.a)
1 2‐17 m 20000 8.75% 1 2‐17 m 8.4% 8.45% 8.55% 8.75%
Prof S N Rao 72
Public Deposit Schemes of
• Bombay Dyeing
• Period: 36 months
• Interest rate: 10% p.a.
• Floated in Aug 2015
• Rating: FBBB+
• Godrej & Boyce Mfg Company
• Period: 3 years
• Interest rate: 9.5% p.a. payable half yearly
• Effective interest rate: 10.25%
• Floated in August 2015
• Rating FAA+
Prof S N Rao 73
Public Deposit Schemes of 2017
Prof S N Rao 75
Rights Debentures
• Amount should not exceed
• 20% of the (GWC – LT funds available for WCF) OR
• 20% of paid‐up capital incl Pref Cap and free reserves , whichever is lower
• D/E ratio, including proposed debenture issue, should not exceed 1:1
• Cost?
Prof S N Rao 76
Debenture Issue of
Shriram Transport Finance Co. Ltd
• Issue size: Rs.500 cr with option to retain over subscription up to
Rs.500 cr
• Issue period: 27 Jul 2009‐14 Aug 2009
• Min amount: Rs.10000
• Maturity: 3 years/5 years
• Interest rate: 10.75% to 11.5%
Prof S N Rao 77
NCD Issue of SREI Equipment Finance Ltd
• Issue Open: Jan 3, 2017 ‐ Jan 20, 2017
»» Issue Type: Fixed Price Issue NCD
»» Issue Size: 5,000,000 NCD's of Rs. 1000
»» Issue Size: Rs. 500.00 Crore
»» Face Value: Rs. 1000 Per NCD
»» Issue Price: Rs. 1000 Per NCD
»» Market Lot: 10 NCD
»» Minimum Order Quantity: 10 NCD
»» Listing At: BSE
• These debt instruments has maturity periods of 400 days, 3 years and 5
years and interest payment options are cumulative, monthly or yearly as
per the choice of investors. The coupon rates are ranging from 8.90 per
cent to 9.75 per cent.
Prof S N Rao 78
Commercial Paper
• Maturity period: 10‐364 days
• Sold at discount redeemed at face value
• Generally held till maturity
Prof S N Rao 79
Commercial Paper
Regulations
• Net worth of at least Rs. 4 cr
• Sanctioned Bank Finance limit
• FV of CPs issued should not exceed WC limit
• Listed company
Prof S N Rao 80
Commercial Paper
• Rated P1/A2 …
• Min CR of 1.33
• Enjoys health code no 1
• Min issue size is Rs.25 lakh and min denomination is Rs.5 lakh
• Cost?
Prof S N Rao 81
CP issue of ONGC Videsh Ltd (OVL)
• Issue size: Rs.5,250 cr
• The largest CP issue in India
• Maturity: 1 year
• Implied yield: 8.15%
• Post‐tax interest cost: 5.5%
• Yield on 1‐year T‐bill: 4.75%
• Guaranteed by ONGC which Cash balance of Rs.25,000 crs
• Issue date: First week of Jan 2009
Prof S N Rao 82
CP issue of ONGC Videsh Ltd (OVL)
• Objective: To part finance the acquisition of UK based Imperial Energy
• Total acquisition price: USD 2.1 b
• CP issue amount: around USD 1b
• Balance amount is provided by ONGC as long‐term debt
Prof S N Rao 83
Size of CP Market
• “The average fortnightly issuance of commercial papers (CPs) increased by
58 per cent to Rs. 47,900 crore during 2014‐15, reflecting substitution of
short‐term bank credit by market based funding on account of the cost
effectiveness of CPs for raising funds on the back of significant easing of
yields on corporate bonds,” RBI’s annual report said.
• Consequently, the outstanding amount of CPs stood higher at Rs. 1.93 lakh
crore at end‐March 2015 as compared to Rs. 1.06 lakh crore at end‐March
2014.
• the weighted average discount rate (WADR) for CPs decreased to 9.26 per
cent at end‐March 2015 from 9.92 per cent at end‐March 2014, RBI said.
Prof S N Rao 84
Factoring
It is a powerful financial instrument specially designed to
meet the post sales working capital requirements of
the industrial, trade & service sectors, it is a portfolio
of complementary financial services. Besides financing
up to 80% of the invoice value, the package includes:
Prof S N Rao 85
Factoring
• Identification of customers and credit analysis
• Debtor collection
• Advisory services
Prof S N Rao 86
Factoring
Types of Factoring
• With – recourse factoring
• Without‐recourse factoring
• Undisclosed factoring
Prof S N Rao 87
Factoring
Benefits of Factoring
• Instant access to cash
• Make payments to creditors, avail cash discounts
• Maintenance of sales ledger
• Collection of debtors
• Clients can focus on other functions
Prof S N Rao 88
Factoring
Eligibility
• Mfg, trading or services company
• Should have sound financial base
• Turnover of not less than Rs.50 lacs
• Strong and prompt customer base
Prof S N Rao 89
Factoring
Where Factoring is not suitable
• Where large volume of cash sales take place
• Engaged in speculative business
• Selling highly specialized capital equipments or
made‐to‐order goods
Prof S N Rao 90
Factoring
• Where credit period offered to the buyers is more than 180 days
• Where there is consignment sale
• Where sales are to the sister/associated companies
• Where sales are to the public at large
• Cost?
Prof S N Rao 91