CHAPTER-1

OVERVIEW OF
CASH MANAGEMENT
 CHAPTER-1

OVERVIEW OF CASH MANAGEMENT

Index
Serial Pg.
Particulars
No. No.
1.1 Introduction 3
1.2 Cash 3
1.3 Meaning of Cash 5
1.4 Meaning of Cash Management 6
1.5 Concept of Cash Management 7
1.6 Advance Cash Management 9
1.7 Objectives of Modern Cash Management 10
1.8 Concept of Cash Conversion Cycle 10
1.9 Cash Planning 11
1.10 Methods of Determining The Optimum Cash Level 12
1.10.1 Conventional Method 14
1.10.1.1 Receipt and Payment Method 14
1.10.1.2 Adjusted Net Income Method 14
1.10.1.3 Other Conventional Method 15
1.10.2 Statistical & Mathematical Method 15
1.10.2.1 Probability Distribution Method 15
1.10.2.2 Linear Regression Method 16
1.10.2.3 Linear Programming Model 16
1.10.3 Inventory Model Method 18
1.10.3.1 Baumol Model 18
1.10.3.2 Miller-Orr Model 19
1.10.3.3 Uncertainty Model-Bernell K. Stone 21
1.11 Control of Cash Flow 23
1.11.1 Accelerating Collection of Cash 23

1
 1.11.1.1 The Order Processing Float 23
1.11.1.2 The Buyer Float 23
1.11.1.3 The Deposit Float 23
1.11.2 Concentration Banking 23
1.11.3 Lock Box System 24
1.11.4 Collection of Payment Personally 24
1.12 Inadequacy of Cash and Its Financing 24
1.13 Investment of Surplus Funds 25
1.13.1 Ready Forward 25
1.13.2 Treasury Bills 25
1.13.3 Certificate of Deposits 26
1.13.4 Commercial Paper 26
1.13.5 Public Deposits 26
1.13.6 Inter-Corporate Deposits 26
1.13.7 Time Bills 27
1.14 Conclusion 27
Reference 28

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 CHAPTER-1

OVERVIEW OF CASH MANAGEMENT

1.1 Introduction

This chapter include the information about the cash and cash management. The
different aspect of cash management as well as its objectives are briefly discussion in this
chapter. Understanding the concept of cash management provides the adequate base to
conduct the further research on this topic. Thus, researcher include various fundamental
aspects of cash and cash management in this chapter

1.2 Cash

In the recent era of cashless transaction in India, cash get less attention than before,
reason why people start doing more cashless and less cash transaction into their daily lives.
Considering the cashless approach, many corporate sector is also doing the cashless
transaction. The present research focus on the cash management practices of the two
selected sample companies and its impact on the profitability as well. Basis on the concept
of cash, it can clearly be stated that, no matter how much cashless company or corporate
sector will be, they need the cash or cash equivalent for their day to day activities.

Since the beginning of the commercial transaction and writing an accounts, cash
has its importance. In old days, the transaction were did with barter system, gradually cash
(money) were came into picture and become most useful rather key factor for financial and
monitory transactions. In respect of corporate sector it can be said that without the proper
cash balance corporate sector cannot be operated. For every activities whether it is day to
day task or any long term investments, cash play a major role to running business smoothly.

It’s rightly said that cash is the most liquid assets of any firm, it like life blood of
the company. In respect of company or firm the cash stand for cash and bank balance.
Merely having cash on hand without knowing the probable requirement does not providing
much benefit to the companies because the requirement rather probable need of cash is
important aspect of carrying cash. This would give the rise of concept called “Level of

3
Cash”. Level of cash means that much cash which can be sufficient to meet daily
requirement of companies and other contingencies.

How much cash is needed which called optimum cash balance is varies as per type
of business because the optimum cash balance for one type of business may not be the
optimum cash balance for the another type.

The process of defining the optimum cash balance for the business give the reason
to formulate efficient cash management policy of the firm. With the help of good cash
management system the firm can achieve its basic objective of profit maximization. No
matter how much fixed assets company have, without adequate cash on hand (liquidity)
company cannot meet its daily expenses. Cash like a fuel of the engine called business.

There are many business which get closed due to poor cash management policy or
lack of proper cash balance. This shows the importance of the efficient cash management
practices of the firm. Cash itself provide financial freedom to firm to have proper
functioning of all its resources. The three main reason why any business can hold the cash
are operational, precautionary and speculative. The cash management related with the cash
flow of the firm with the due reason that inflow and outflow of cash ultimately decide the
level of optimum cash balance in the firm. Cash as a part of working capital needs great
attention of financial manager of company as compared to the other component of working
capital.

It’s very common saying that cash is the life blood of the firm. This statement shows
the importance of cash in the business operations. This discussion is related to cash and cash
management policy which tries to identify the best possible way to manage the cash for the
various business purpose. In order to understand various aspect about the cash, first we need
to clear the meaning of cash in reference to business activities. Cash is any medium of
exchange, which is immediately negotiable. It must be free of restriction for any business
purpose. Cash should meet the prime requirements of general acceptability and availability
for instant use in purchasing asset and payment of liability. Bank’s acceptability for deposit
is a common test applied to cash items. It is channeling available cash into expenditures that
enhance productivity, directly or indirectly.

Cash plays a role of important current asset in the operations of the business. For
continues running of business cash is basic input. The firm should keep sufficient cash,
neither more nor less. Condition of shortage or excess of cash availability is harmful, which

4
contributing nothing towards the tint's profitability. Thus, a major function of the financial
manager is to maintain a good cash position.

The term cash includes coins, currency and cheques held by the firm, and balances in
its bank accounts. In cash, marketable securities and bank time deposit also included
sometimes. The basic characteristic of near-cash assets is that they can readily be available
for conversion in cash. When a firm has excess cash, marketable securities may be purchased.
This kind of investment contributes some profit to the firm. A business must have enough
cash to meet its obligations or it will be declared bankrupt. Creditors, employees and lenders
expect to be paid on time and cash is the required medium of exchange.

Determining the appropriate cash target balance involves an assessment of the tradeoff
between the benefits and cost of liquidity. The reason of holding the cash is the convenience
it gives to the firm. A firm should increase its holding cash until its present value from doing
so is zero. The incremental liquid value of cash should decline as more of it is held.

Though in late 1990s some development and discussions had been advanced, yet
contributions kept on increasing from that era then. Pandey (2008) has provided in his book
that cash management is concerned with managing of cash flows into and out the firm as
well as cash flows within the firm. He further add that in order to resolve the uncertainty
about cash flow prediction and lack of synchronization of receipts and payments of cash, an
appropriate strategies for cash management should be develop by the firm. The firm’s
strategies should include following four facets of cash management which is planning,
managing the cash flows, Optimum cash level, investing surplus cash.

1.3 Meaning of Cash

The cash, as in its dictionary form, refer as Ready Money which include coins and
currency. Money or its equivalent which is paid for purchasing goods or services is also
consider as cash.

For accounting purpose, cash includes money (cash) in hand, petty cash, bank
account balance, customer cheques and marketable securities. Cash is the most liquid form
of asset in company which used for meet routine expenditures. Cash is one form of money.
The cash is define as the very common medium of exchange or purchasing power. In a
financial terms, it refers to all money elements and sources which are immediately used for
paying a firm’s bills. Initially, cash is invested in fixed assets of company like machinery,

5
tools, furniture, plant etc. This helps the company to run its business as well as generate
cash by selling its product or service.

1.4 Meaning of Cash Management

The cash management topic cannot be discussed in isolated manner because cash
affected largely by debtors and creditors. The cash management as a significant activity in
the company has its own importance. The efficiency of managing cash and cash
equivalents, not only provide the liquidity to the company but also increase the profitability.

The systematic process of handling the inflow and outflow of the cash with object
to attain optimum cash balance can be define as a “Cash Management”. The shorter cash
conversion cycle is also one of the objective of cash management.

The shorter cash conversion cycle can be attain through reducing the receivable
collection days, inventory outstanding days and increasing the payable outstanding day. No
any readymade plan is available for formulating the cash management policy for the
corporate sector, companies need to evaluate and analyze its investing pattern, its credit
policy, inventory requirements, turnover period and creditors outstanding days to formulate
the suitable cash management policy.

Cash flow indicate the net amount of cash and cash equivalents which is moving
into and out of a business. Positive cash flow shows that a company’s liquid assets are
increasing which enabling it to settle debts, reinvest in its business, return money to
shareholders, pay expenses and provide reserve against future financial challenges.

Net cash flow derived from net income, which includes accounts receivable and
other items for which payment is yet not actually been received. Cash flow helps to decide
the solvency of the company and liquidity position.

Sometimes the cash inflow and outflow is faster and sometimes it is slow. So cash
play an important role in every business through the process of conversion cycle. And such
conversion can be easily realized with the help of working capital cycle in which cash play
a vital role. The below given figure explain cash conversion cycle (CCC) of different type
of organization. The management of cash is crucial task for any business as the deficit of
cash may lead to the stoppage of business operations. The cash conversion cycle is useful
to measure the efficiency of cash management by company.

6
 I. Cash Conversion Cycle of trading firm
Figure-1.1
A Figure Showing CCC of Trading Firm

Cash

Goods
(Merchandise)

II. Cash Conversion Cycle of Manufacturing Firm

Figure-1.2
A Figure Showing CCC of Manufacturing Firm

Cash

Material , Labour
Debtors
and other expenses

Finished
Sales
Goods

1.5 Concept of Cash Management

The main object of company is to have optimum balance of cash which provides
smooth functioning of business. Though cash having small part in total current assets but
it required great attention of finance manager to maintain the appropriate cash balance. The
main area of cash management includes cash flow, internal flow of cash and investing

7
surplus or borrowing deficit cash balance. While considering the area of cash management,
other area like collection from sales, paying to creditors, emergency requirement of cash
are also need proper attention. The activity of cash management has to be in such a manner
which allows a firm to have adequate liquidity. For this planning of the cash is necessary
in which different techniques are used by firm do planning of cash.

If firm can forecast the cash in proper manner then it is easy to meet the requirement
of cash by firm. Due to advance technique and usage of various software company now a
days has ability to forecast the cash in more accurate way and manage the cash and cash
movement in better way. In respect of forecasting cash inflow and outflow firm require
good information about past movement of cash and idea of present cash flow situation in
business. The firm also try to minimize the deviation between forecasted cash flow and
actual cash flow. It is not necessary that company which has good profitability is also
having good liquidity condition because if company has its working capital tied up in some
components of assets which cannot converted into cash in short time duration then liquidity
of the company is inadequate. Thus to avoid this situation, firm should maintain proper
balance between liquidity and profitability as they both has inverse relationship.

The manager inflow of any firm is the sales of that firm and major outflow is
creditors. Thus by managing the sales especially credit sales company can maintain
adequate liquidity in firm. To meet the shortage of cash is also one objective of cash
management. No firm has exact balance between collection and payment period of cash
because of which firm need to arrange the cash for the difference period between collection
and payment of cash. If firm gets the collection first that is short collection period and need
to pay later that is long payment period then firm need not to arrange extra cash to meets
its payment requirement but if company has short payment period and long collection
period then firm need to arrange the cash for the period of difference between collection
and payment. This is called cash conversion cycle in which firm measure the days for which
arrangement of cash is necessary to meet the payment liability of firm.

In order to resolve the uncertainty of cash flow predication and lack of

synchronization between receipt and payment of cash in company, firm should develop
appropriate strategy for cash management in which firm should consider the different facts
of cash management which are as follow.

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Cash Planning: For the cash planning, cash budget is prepare by the firm in which inflow
and outflow are predicted and found whether company has surplus or deficit of cash and
make arrangement accordingly.

Managing The Cash Flow: In order to avoid cash deficit situation, firm need to manage
the cash flow accordingly in which cash inflow need acceleration and cash outflow need
deceleration.

Optimum Cash Level: No standard level is available as far as optimum cash level is
concern because level are different as per different company and situation. The optimum
cash level is decided by matching the cost of excess cash and danger of cash deficit in firm.

Investing surplus cash or arranging deficit cash: This is also important aspect for cash
management. When there is surplus cash it should be invested in short term marketable
securities, banking deposit and inter corporate lending and in a situation deficit cash firm
should borrow cash from market.

The ideal cash management system will depend many factors like product of the
firm, structure of organization, level of competition in market, culture of firm, market
situations, type of production process and other available options.

The decision of cash management cannot be taken in isolation as the cash

management decision is affect the other important area of business, for example in order to
improve collections if credit period is reduce then it may affect sales.

In certain cases even without fundamental changes it is possible to significantly

reduce the cost of cash management system by choosing a right bank and proper controlling
over collection.

1.6 Advance Cash Management

The cash management is an integrated and overall service of which the firm takes
the appropriate decision in appropriate time. The treasury management is regarded as
theory for few decades. Now the scenario of business is different. In this, economic
environment, risk reduction and efficiencies of cash management is consider in corporate
success. Other functions like risk management, interest exchange rate and contractual
relationships with financial institution should be added to a new concept of management of
cash for improving the profitability at minimum risk and other conditions. So as per this

9
point of view, Treasury Management or Cash Management is a broad concept which
includes availability, planning, profitability and financial risk with liquidity management.
More specifically cash management is a set of strategic measure which concerned with
working capital, risk management, banking relationships and planning to give effect to the
cash flow and different financial result of the firms.

1.7 Objectives of Modern Cash Management

The following are objectives of modern cash management are as follow:

1.7.1 To borrow the funds whenever required by firm. Unnecessary allocation of funds
results in pressure on cash outflow of the funds.
1.7.2 To confirm that the adequate cash balance is available for payment of expenditures
when they are due. Revenue allocation can facilitate this objective.
1.7.3 To manage business risk and financial risk in such a way that it increases the surplus
productivity as against the adequate collateral.
1.7.4 To maximize the return on idle cash balance. It means to avoid the accumulation of
unremunerated or low yielding government deposits in the commercial banks.
1.8 Concept of Cash Conversion Cycle
The Cash Conversion Cycle is define as length of time between purchase of raw-
materials and collection of cash from debtors. In the area of liquidity management, Cash
Conversion Cycle is an important parameter which measure efficiency of company. The
Cash Conversion Cycle is indicates the efficiency of managing working capital. For the
purpose of measuring Cash Conversion Cycle, payable deferral period is deducted from the
addition of inventory conversion period and receivable collection period.
The Cash Conversion Cycle (CCC) is a useful technique which can easily and
quickly assess the liquidity of firm. Traditionally some static balance sheet value such as
quick ratio and current ratio are useful indicators of liquidity but in case of CCC, it is a
dynamic measure of continuous liquidity management.

The Cash Conversion Cycle is Cash Gap. Cash Gap measures the length of time
between actual cash expenditures on resources and actual cash receipts from the sale of
services or product. It is one of the easiest procedures to measure the cash movement of the
firm.

 Equation for calculating cash conversion cycle is as follow.

10
 CCC = Days of Sales Outstanding + Days of Inventory Outstanding- Days of Payable
Outstanding.
 The calculation of various ratio for CCC is as follow.
Days of Sales Outstanding = Account Receivables/Sales*365
Days of Inventory Outstanding = Average inventory/COGS*365
Days of Payable Outstanding = Account Payable/COGS*365

The Cash Conversion Cycle (CCC) can be positive or negative. A positive CCC
indicates that number of days a company is borrowing is less than the period of payment
from a customer. On the other hand, negative CCC indicate the number of days a company
received cash from its sales before it must pay its supplier. The more attention of company
is to minimize its days of CCC, if possible try to make negative. Company is more efficient
in managing its cash flows if it has shorter CCC.

Form the above information of CCC, it is seen that a company can reduce its need
for working capital by following ways

I. Reducing the inventory time period. This can be done by improving the process of
the inventory or suppliers deliver the goods when production required that inventory.
II. Early collection of account receivable. This can also be done by improving the
efficiency of the collection procedure, providing discounts to customers for faster
collection and impose interest on those accounts which are due for long period.
III. Reasonably slow payment to creditors. This can be done by improving relation with
suppliers or creditors.
1.9 Cash Planning

The crucial part of corporate cash management is cash planning. By proper cash
management, company try to achieve optimum cash level. The future cash requirement and
flow of cash is predicted and control with the help of cash planning. The major part of cash
planning is to forecast the cash inflow and cash outflow for the present and future
anticipated period. While considering the various aspect of cash, factors affecting cash and
liquidity position of firm planning of cash can be properly done.

The requirement of cash planning in the firm is understand better in the situation of
deficit of cash in business. The cash flow plays major role in framing the strategy for cash
management. As the all estimation are around the two major function one is cash inflow

11
and other cash outflow, if inflow is quick and outflow is having long period then there is
surplus of cash and no any difficulties are arise for firm but if outflow has short period and
inflow of cash take long period then there is a situation of cash deficit.

In the situation of cash deficit need of cash planning is more, in this situation firm
try to predict the probable inflow and outflow of cash and make the arrangement of cash
accordingly if cash deficit is arise. On other hand, firm has cash surplus as per prediction
then it should be invested in some profitable manner.

Cash planning may be daily, weekly and monthly basis. The frequency and period
of cash planning generally depends on size of business, number of transactions and
philosophy of management. Generally, large firm prefer cash planning on daily basis
frequency of transaction are more and need a daily attention to supervise the inflow and
outflow of cash. While medium size firm prefer weekly cash planning as having small firm
size and comparatively less number of transaction.

The small size firm prefer monthly planning of cash and in some cases they do not
prefer cash planning as having limited transaction and direct connection with cash inflow
and outflow.

Thus cash planning is a crucial part of cash management which prevents the firm’s
cash deficit situation and try to get proper balance between cash inflow and cash outflow.
It also provide the scope of prediction of cash flow and requirement of cash.

1.10 Methods of Determining The Optimum Cash Level

There is no such standard available to decide how much cash is consider as optimum
cash balance for any firm, based on cash inflow, outflow, nature of business, requirement
of cash and philosophy of management firm decide the optimum cash level for it. The
optimum cash level is different as per different industries and situations.

The aim of deciding the optimum cash balance is to avoid the situation of surplus
or deficit of cash which becomes the reason for opportunity cost or interest cost of
borrowing cash in cash of deficit. For the purpose of deciding the optimum cash balance
some techniques are used by the firm which provide the idea of optimum level of cash. The
method of determining the optimum cash level are broadly classified into three categories
which are as follow.

12
 Figure-1.3
A Figure Showing Method of Calculating Optimum Cash Level

Optimum Cash
Balance

Conventional Statistical & Inventory Model

Method Mathematical Method
Method

Adjusted Baumol Uncertainty

Receipt & Other Probability Linear Linear Mirror-
Net Model Model-
Payment Conventional Distribution Regression Programming orr
Income Bernell K.
Method Method Method Method Method Model
Method Stone

13
1.10.1 Conventional Method
1.10.2 Statistical & Mathematical Method
1.10.3 Inventory Model Method

1.10.1 Conventional Method

The various traditional methods are available to determine the optimum level of
cash. The conventional method are as follows.

1.10.1.1 Receipt and Payment Method

The generally used method of forecasting short term cash level is receipt and
payment method. In this method, company predict the receipt and payment of cash for
particular period. The various type of cash receipt and payments are as under.

I. Estimated Sales- ( both cash and credit sales)

II. Purchase Plan
III. Capital Expenditure Budget
IV. Financing Plan
V. Production Plan

Out of all this items more important item is estimation of sale because various
other type of plan and estimates are generally based on sales figure. Thus more attention
should to pay cash estimation which ultimately provides the source for adequate cash.
By using this method, firm can predict the receipt and payment and try to achieve the
situation of synchronization between receipt and payment as much as possible.

1.10.1.2 Adjusted Net Income Method

This method of forecasting the cash is based on tracing of working capital flows.
It is also called sources and usage approach. This method use to achieve to objectives,
first to project the company’s need of cash for future and second to show whether
company can generate the required funds internally, and if not, then how much required
to borrow from capital market.

It is, in fact, a projected cash flow statement based on Performa financial

statement. This method has three sections namely source of cash, uses of cash and the

14
adjusted cash balance. This procedure useful in adjusting estimated earnings on an
accrual basis to a cash basis. It also useful in anticipation of the working capital
movements. The items such as taxes, depreciation, net income, dividend, routine
expenses etc., can easily be determined from the annual operating budget of company
while preparing the adjusted net income forecasts.

1.10.1.3 Other Conventional Method

In this category, a certain percentage of sales, a certain percentage of current

assets, the average relationship between the two attributes in the past and cash in terms
of number of days of current obligation is used to make future predictions. This
techniques might not provide accurate estimations in a growing economy, because of
which they are not popular in organization.

1.10.2 Statistical & Mathematical Method

In the statistical and mathematical method of forecasting cash the three methods
are used. By using this method, the firm can estimate the optimum level of cash for the
particular time period. After adopting particular method, firm analyze that how much
cash balance is sufficient for the particular period of time.

1.10.2.1 Probability Distribution Method

This method may be define as a range of estimates of the likely future outcomes.
In this method, expected value is defined as the most likely or average estimate of the
cash inflows. It also determined by total cash inflows over a period of time is divided
by the number of days in the period.

This method shows the fact that an estimated value is single value usually at the
center of a possible range of values. By using this firm may forecast a level of cash.
One distinguishing point of this method is that cash forecast is not a point estimate
rather it will be a range or expected value of possible cash levels.

The exact level of cash will be determined by real business forces. In stable
environment firm can have more compact probability distribution. In fluctuating
environment, the expected value may remain same but the range of inflows of cash and
outflows of cash may vary significantly. So, by using this method firm can decide the
optimum level of cash balance.

15
1.10.2.2 Linear Regression Method

In the linear regression method, past collected data is arrange systematically and
analyzed to give it the shape of linear line which is used in future predictions. This may
be done with the help of fitting a line of best fit i.e. the sum of squares of deviations of
actual from expected values is the minimum. The example of linear regression line is
as follow.

Y=a+bx

Where, Y means dependent value or the predicted value

a means the minimum constant value of the dependent value

b means the rate of growth of the dependent value

x means the independent value

For example suppose cash flows is related with volume of sales. The past data
of cash flows and sales are analyzed to determine the degree of co-variability between
the two and give the shape of a regression line which is used for future cash predications
at the given levels of sales.

This method helps the analyst in drawing more accurate result, but they must be
keep in mind several points while using this method which are as follows.

 The linear relation may not be accurate. The real relation may be curvilinear and a
more powerful statistical technique may be used.
 The degree of co-variability between the two variables may change in future, thus
the predicted values may not as closer as actual ones.
 It happens that sometimes only two variable are not enough to describe relationship.
Thus, some additional statistical technique is used to supplement the outcomes as
obtained by the use of linear regression method.

1.10.2.3 Linear Programming Model

Under this model, an attempt has been made to get more authentic and reliable
outcome by inter-relation of larger number of variables. The model was design to
optimize operating decisions which is subject to various financial elements including
the opportunity cost of the long term funds. Various linear programming models haven

16
been developed from time to time to deal with the problem of optimizing cash balance
within the present framework of financial elements. Out of that, one such model known
as the ‘Orgler’s Model’ is describe as follow.

As it takes into consideration a various number of constraints and due to

possessing ability to forecast even during uneven periods the Orgler’s Model is consider
as most comprehensive linear programming models. The various constraints used in
Orgler’s Model are as follow:

I. Payments: Here, payments refer to account payable which are subject to credit
terms as specify by the creditor and which are due for payment during the period
under consideration. The other payments than accounts payables can also
suitably use in this model if they are controllable.
II. Sale of Securities: This constraint related with the proceeds of sale of securities.
Here it is assumed that the securities are sold at the beginning of the day.
III. Short-term financing: Under this constraint, all sources of short-term financing
except proceeding from sale of securities. As the short-term financing affects
other financing also so it must be properly accounted for.
IV. Cash flows: Under this constraints, other cash receipts and payments which are
beyond the control of the manager is cover.
V. Minimum Cash Balance: This model assume that certain minimum level of cash
must be maintained by the organization all the times. This is the minimum cash
balance which is require to keep the organization in smooth functioning.

The Orgler’s model, with the above mentioned constraints is seems to be quite
complete and comprehensive. But it is not free from limitations. The main limitation is
being its comprehensiveness.

For big organization, it is not possible to define all the constraints so as to be

included in this model and attaining realistic results. Another drawback is that it
requires continuous updating of the model with the changing business scenario due to
which more maintenance and expense are required.

Further, this model is assume that cash flows and interest rates are known in
advance with certainty, which is seems to be unrealistic assumption. Begin more
sophisticated is also one of the limitation of this model as it is beyond the
comprehension of the user with normal skills.

17
 It requires comparatively longer time to develop the constraint for initial model.
So due to this limitations, this model is also not very popular among the users.

1.10.3 Inventory Model Method

There are mainly three types of models that are available for cash forecasting
under this head which are discuss below.

1.10.3.1 Baumol Model

William J. Baumol applies the EOQ models in his article on cash management
for the purpose of identifying the problem of cash management. According to Boumol,
there must have some fundamental similarities between inventory and cash from
financial aspect. In case of inventory ‘ordering’ and ‘stock-out’ costs are important
aspects. Such cost may be expensive if the inventory level come down to zero and for
placing orders in the situation of immediate requirements. On other hand, holding
inventories also incur some costs. The similar situation can be also occur with cash and
securities. There are also ordering cost. It may be in the form of brokerage fee and
clerical work at the time of transfers between investment portfolio and cash account.
On other hand, holding cost of interest forgone may also need to consider when large
amount of funds remain unutilized. The cost related with running out of cash also very
important as well as similar to stock out cost of inventories. By maintaining optimum
cash balance such cost can be minimize.

The Baumol model for cash management provides a formal approach to

determine an optimum cash balance of firm under certainty. This model considers cash
management as similar to an inventory management problem. So, the firm try to
minimize the sum of the cost of holding cash and the cost of converting marketable
securities into cash.

The assumptions of this model are as follow

 The firm is able to forecast its need of cash with certainty.

 The payments of cash occur uniformly in firm 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 in
cash.

18
 This model is usually used in inventory management but has its application in
determining the optimal level of cash also. As Economic Order Quantity (EOQ) in
inventory management shows the tradeoff between carrying costs and ordering cost,
the optimal cash balance is the tradeoff between opportunity cost or cost of borrowing
or holding cash and the transaction cost i.e. the cost of converting marketable securities
into cash.

The optimum cash balance is reached at a point where the total cost is the
minimum which include holding (opportunity cost) and transaction cost. The Figure
below shows the optimum cash balance.

Figure-1.4
A Figure Showing Baumol Cash Management Model

1.10.3.2 Miller-Orr Model

Baumol’s model is based on the basic assumption that the timing and size of
cash flows are known with certainty. This usually does not happen in reality. The cash
flow of a firm are neither uniform nor certain. Thus, Miller and Orr model overcomes
the limitations of Baumol model. Merton Miller and Daniel Orr extended the model
prepared by Boumol in which they adopt a stochastic generating process for periodic
changes in cash balance due to which cash pattern should show the resembling pattern.
Miller-Orr assumes that the cash flows behave as if they were generated by a ‘stationary
random walk’. This indicate that changes in the cash balance over a given period are

19
random in both direction and size and indicate a normal distribution as the number of
period increases.

The Miller-Orr model is designed to find out the time and size of transfers
between an investment account and the cash account depending upon the decision
process.

In this model, two control limits and one return point are used like upper control
limit, return point and lower control limit. This model includes the cost of making
transfers from cash to investment portfolio and opportunity cost of holding cash.

Under this model, upper limit means the limit which cash balance should not be
allowed to cross, the return point to which the balance is returned after every transfer
to or from cash account which minimizes the cost function.

The lower limit is given and it should be the minimum balance maintained by
the bank in which cash is deposited.

Figure-1.5
A Figure Showing Miller-Orr Cash Management Model

The Figure-1.5 shows that when the cash balance touches the upper control limit
(H), marketable securities are purchased by the company to the extent of HZ to return
back to the normal cash balance of Z point. In the same manner when the cash balance
goes down and touches lower control limit (O) then firm will sell the marketable
securities to the extent of OZ to again return to the normal cash balance.

The return point or the spread between upper and lower cash balance limit
(called Z) is showing the optimum balance of cash for the firm and can be computed
by using Miller-Orr model as follow.

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 Variance of Cash Flows = (Standard deviation) 2 or (S) 2.

The Miller and Orr prepared the model by using data relating to the daily cash
balances, purchases and sales of short-term securities of a large industrial company for
a period of nine months. The average daily cash balance predicted under this model is
forty percent lower than that of the actual cash balance computed by the company’s
treasurer. As like other inventory control models, its efficiency not only depends on the
conditional predictions like expected number of transfer and the expected average cash
balance but also on the estimated parameters. Here to estimate the transfer cost is
difficult task. According to the Miller and Orr ordering cost include various component
which are as follow:

I. Making two or more long distance phone calls plus fifteen minutes to half-hour
of the assistant time of treasurer.
II. Typing and carefully checking and authorization letter with four copies.
III. Carrying the original of the letter to be signed by the treasurer, and
IV. Carrying the copies to the controller’s office where special accounts are opened,
the entries are posted and further checks of the arithmetic are done.

In this model Miller and Orr does not rely on the order costs and they used the
same number of transactions as computed by the treasurer. They opine that the order
costs implied by the own action of treasurer. It then evaluate the treasurer’s
performance in managing the cash balances and provide valuable information to the
treasurer.

1.10.3.3 Uncertainty Model-Bernell K. Stone

In this model, Bernell found that Boumol model is based on complete certainty
and Miller-Orr model base on complete uncertainty while deciding the optimum cash
balance. The Bernell then assume that no forecasting of cash if complete certain nor it
is complete uncertain. There are some elements in which are certain and some elements
which are uncertain. Thus both certain and uncertain elements are affects the decision
of optimum cash balance.

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 This model is based on the argument that average cash and bank balance is
determined by bank’s requirement of maintaining compensatory bank balance in
current account when an overdraft facility is used. The objective and functioning
therefore shifts from balancing opportunity cost and security transaction costs to
minimizing transaction costs subject to the constraint that the average balance must
always be equal to the target balance.

According to Bernell Stone, cash flows can be divided into two parts one which
is random and the other which can be forecasted. Therefore he uses control limits
similar to that in Miller and Orr model except that two sets of limits are also prescribes
which are outer limit and inner limits. When cash (bank) balance touches the outer limit,
the finance manager does not intend to purchase securities, as in the case of Miller and
Orr Model, but checks with the forecasts for the next pre-determined days (which are
normally a few days only, say three days).

If he finds that the forecasted cash flow is expected to move within the inner
limits, i.e. the balance is closer to target balance then he does not order any securities
transactions and hence can saves on transaction costs. If, however, the forecasted cash
is outside the inner limits i.e. the closing balance is far away from the target balance
then he orders buying or selling of securities to the extent that closing balance at the
end of predetermined days become equal to the target cash balance.

The three models discussed above are based on a different assumptions like
deterministic (Boumol), purely random (Miller and Orr) and then a combination of both
(Bernell K. Stone). In real situations, cash flows are expected to fit into any or a
combination of these assumptions. This thing can compare with intuitive judgement of
the finance manager which may ultimately lead to the development of a cash
management model which is uniquely suitable for a firm. It should also consider that
none of the above models have earned unqualified success. Often, simple rules of thumb
have been found to be performing just as well. The conclusion of matter is that none of
these cash management models should be applied mechanistically.

It has been point in practice that still companies are using traditional method of
cash forecasting i.e. The Receipt and Payment Method and The Net Adjusted Balance
Method. The other statistical method and advanced inventory models are not in use for
the reason discussed earlier.

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1.11 Control of Cash Flows

The control of cash flows seek adherence of actual cash flows to the budgeted
ones as far as possible. The available technique for the purpose of control over cash
flows are the preparation of a Cash Reports and Cash Budget. Once the cash budget is
ready and the optimum net cash balance is known, the financial manager would aim
that the actual cash flows in the projected manner without much significant variations.
However, if there are marked variations as reported by the cash report that may be the
due to reason of wrong or improper implementation of the budgets. Hence corrective
steps should be taken in the manner of revising the budgets if warranted by the
circumstances and by exercising control over cash flow. The objective of cash control
is fulfill by accelerating cash collections as far as possible and delaying cash payments
to the reasonable possible manner.

1.11.1 Accelerating Collections of Cash

A firm can reduce its demand of cash by speeding up collections or in other

words by reducing the credit period given. The whole period between placing an order
and the time funds become available to the firm for use can be divided mainly in three
parts which are as follows.

1.11.1.1 The Order Processing Float: The time span between receipt of an order and
execution of that order which is known as the order processing float.
1.11.1.2 The Buyer Float: The time taken by the buyer in honoring the bill which is
known as buyer float.
1.11.1.3 The Deposit Float: The time between the moment when the payment is made
by the debtors or customer and the moment the funds become available to the
firm for use. In other words, the time lag for which the funds remain in transit
which is called the deposit float.

The last phase of float mentioned above is most crucial. The firms employ
different techniques to minimize the time for which the funds remain in transit.

1.11.2 Concentration Banking

The concentration banking is useful technique of speedy collections. Under this

technique a large concern having its operations over a wide territory functions through

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a proper network of collection centers spread over the areas where it has its branches.
All the branches may not hanve this collection centers. The collection centers are collect
the cheques from the customers within their territory and deposit that cheques in their
local bank accounts. After that, the centers transfer such collected funds to the central
bank account as instructed by the head office on routine or daily basis. Thus, through
this process mailing and processing time is saved and collection become quick.

1.11.3 Lock Box System

As the name of this technique suggest Lock Box means under this system the
firm hires a number of post offices boxes at different centers where its customers are
generally located. The main bank of the firm is required to pick up collections from
these local boxes on daily basis. The main advantage of this system is that the cheque
is deposited immediately on its receipt after its receipt as the collection is handled by
the bank itself. The bank handles the collections process comparatively at a low cost.

1.11.4 Collection of Payments Personally

Under this method, local sales representatives require to collect the payments
and send them directly to the head office. This is more personalized and effective way
of getting collection speedily. The main drawback of this method is the time taken by
the local representatives in the submission of collection to the main bank account.

1.12 Inadequacy of Cash and Its Financing

The inadequacy of cash or shortage of cash is a situation when cash outflows are
more than cash inflows. Such shortages of cash should be arrange quickly, otherwise it
will bring discredit to the concern or it may even become a reason for liquidation of the
firm inspite of strong financial position in the long run. A firm can arrange cash for
such temporary shortages by following ways:

I. By resorting to short term bank loans.

II. By resorting to discounting of bills.
III. By disposing off marketable securities.
IV. By postponing Payments.
V. By disposing off surplus raw materials and finished goods.
VI. By utilizing short term loans other than bank loan.

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 The cash shortages even for a short duration may create many problems for the
firm. It breaks down the morale of the management due to which weakens its
negotiating power with the bankers and suppliers. The firm may not be in a position to
avail cash discount due to its inability to fulfill its commitment in time. In this situation,
banker try to cover charge for their loans. In other words, the whole working
atmosphere starts turning into unfavorable conditions. Thus, it need a prompt remedial
measure.

1.13 Investment of Surplus Funds

The cash surplus is a situation where cash inflows are more than cash outflows.
The firm should invest such surplus in a manner which is safe and comparatively liquid.
For this purpose various options are available to the firm, depending upon the varying
degree of risks, liquidity and matching income generation. Some good avenues for
investment are as follow.

1.13.1 Ready Forward

This option represents the deal of sale of some specified securities, which is to
be purchased back by the seller itself at a later date i.e. forward, at a ready or
predetermined price. That is why, it is called ‘Ready Forward’.

Under this option, the banks and some other organizations may sell some
specified securities to a firm, at a certain price, but on the condition that the same
securities will be purchased back by the seller, on a predetermined data, and at a
somewhat higher price, mutually agreed upon the time of the sale of securities.

This way the bank may upload some of specified securities purchased by it to
meet its Statutory Liquidity Ratio requirement to invest or advance the funds, so
generated, elsewhere at a higher yield. On other hand, the company is also able to park
its cash surplus for a specific period, safely as well as with sure liquidity. Here the price
difference between purchase and sale price is the yield to the firm, instead of the interest
on the invested amount.

1.13.2 Treasury Bills

The investments in treasury bills is safe option, as these are issued by the RBI
(Reserve Bank of India) on behalf of the Government of India.

25
 Generally, the issue period of treasury bills is 91 days, 182 days and 364 days
and at a discount. Thus, the rate of interest is the function of the rate of discount and
the period of maturity of treasury bills.

1.13.3 Certificate of Deposits

The certificate of deposit are issued by the banks for a specific amount and for
a specific period. It may be issued in bearer form besides in the registered form. Further,
this certificate is traded even in the secondary market. This certificates are issued at a
specified rate of interest, where the yield is somewhat higher than Treasury Bills.

1.13.4 Commercial Paper

This are the unsecured money market instruments which is issued in the form
of promissory notes. It may also either physical form or dematerialized form and at a
discount to the face value.

1.13.5 Public Deposits

The public deposits are also unsecured deposits, solicited and accepted by large
and small companies and mainly for the purpose of meeting their working capital
requirements.

1.13.6 Inter-Corporate Deposits

This is the deposits made by one corporate body to another and consider as
unsecured deposits. The maturity period of this deposits, however varies from
minimum one day notice to maximum period of six months. Three type of inter
corporate deposits are there which mention below.

I. Call Deposits: This deposits are payable on demand, on one day notice. But
usually, it takes around two or three days, to effect the actual payment.
II. Three Months Deposits: This deposits are payable on demand within three
months.
III. Six Months Deposits: In this deposits time period is six months which is the
maximum maturity period permitted on inter corporate deposits.

26
1.13.7 Time Bills

As the demand bills are purchased and discounted by the bank, the same facility
may be granted by even the companies in the form of time bill by those companies
which are not having any surplus funds temporarily.

Thus, the decision of investing surplus fund may vary from company to
company depending upon the size of surplus and the time for which cash is surplus as
well as the opportunities for short term fund utilization.

1.14 Conclusion

As the various aspect of the cash in required to be consider while preparing the
best suitable cash management practices, researcher include the various elements of
cash in this chapter. The basic concept of cash and cash management are also provide
the insight to researcher about the importance of cash. The motives of holding cash and
different model of determining the optimum level of cash is also an important part of
this chapter. Thus, researcher conclude that this chapter is useful in order to understand
the concept of cash, its various elements as well as its importance.

27
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