OUTLINE

Motives for Holding Cash

Cash Budgeting
Long-term Cash Forecasting
Reports for Control
Cash Collection and Disbursement
Optimal Cash Balance
Investment of Surplus Funds
Cash Management Models

MOTIVES FOR HOLDING CASH

Possible motives for holding cash :
Transaction motive
Precautionary motive
Speculative motive

CASH BUDGET
The principal method of cash budgeting is the receipts and
disbursements method. Under this method, the cash forecast
shows the timing and magnitude of cash receipts and
disbursements over the forecast period.
Illustration

The following information about Beta Company is given:

The estimated sales for the period January 20X1 through June
20X1 are as
follows: Rs.100,000 a month from January through March and
Rs.120,000 a
month from April through June.
The sales for November and December of the previous year
have been
Rs.100,000 each.
Cash and credit sales are expected to be 20 percent and 80
percent respectively.
The receivables from credit sales are expected to be collected
as follows: 50
percent after one month and the balance 50 percent after two
months.

CASH BUDGETING
January

February

March

1. Sales
120,000 120,000

100,000

100,000

100,000 120,000

2. Credit sales
96,000 96,000

80,000

80,000

80,000

96,000

80,000

80,000

80,000

80,000

20,000

20,000

20,000

24,000

May

June

3. Collection of
accounts
receivables
88,000 96,000
4. Cash
sales24,000
24,000

5. Receipt from
machine sale
6. Interest
Total cash
receipts
100,000
112,000 122,000
(3+4+5+6)

April

5,000
2,000
100,000

105,000 104,000

CASH BUDGETING
Relevant information for cash payments
Beta Company plans to purchase materials worth
Rs.40,000 in January and February and materials worth
Rs.48,000 each month from March through June.
Payments will be made a month after the purchase
A payment of Rs.40000 will be made in January for
purchases in the previous December
Miscellaneous cash purchases of Rs.2000 per month
are planned from January through June
Wage payments will be Rs.15000 per month, January
through June
Payments for manufacturing expenses will be
Rs.20,000 per month and for general administrative
expenses will be Rs.10,000 per month, January through
June
Dividend payment of Rs.20,000 and a tax payment of
Rs.20,000 are planned for June

CASH BUDGETING
January
May
1. Material

February

March

April

June

purchases
40,000
40,000
48,000
48,000
48,000 48,000
2. Credit material
purchases
40,000
40,000
48,000
48,000
48,000 48,000
3. Payment of
40,000
40,000
40,000
48,000
48,000 48,000
accounts
payable
4. Miscellaneous
2,000
2,000
2,000
2,000
2,000
2,000
cash purchases
5. Wages
15,000
15,000
15,000
15,000
15,000
15,000
6. Manufacturing
exp.
20,000
20,000
20,000
20,000
20,000
20,000
7. General admn.
expense
10,000
10,000
10,000
10,000
10,000
10,000
8. Dividend
20,000
9. Tax
20,000
10. Capital
50,000
- expenditure
Total
payments
87,000
87,000
137,000
95,000
95,000
135,000
(3+4+5+6+7+8+9+10)

CASH BUDGETING
Assuming that the cash balance on 1st January is Rs.22,000 and the minimum cash
balance
required by the firm is Rs.20,000, the summary cash forecast is given below.
January
1. Opening cash
balance

February

March

April

May

June

Rs.22,000

2. Receipts
112,000 122,000
3. Payments
135,000

100,000
87,000

4. Net cash flow (2 3)

17,000 (13,000)
5. Cumulative net
cash
flow 7,000
20,000
6. Opening cash
balance +
Cumulative
net flow (1 + 5)
42,000
29,000
7. Minimum cash balance
required
20,000
20,000
8. Surplus or deficit in
22,000
9,000
relation to the minimum
cash balance required

87,000

100,000

105,000 104,000

137,000

95,000

95,000

13,000

13,000

(32,000)

9,000

13,000

26,000

(6,000)

3,000

35,000
20,000
15,000

48,000
20,000
28,000

16,000
20,000
(4,000)

25,000
20,000
5,000

LONG-TERM CASH FORECASTING

Adjusted net income method is generally used for long-term cash
forecasting.

REPORTS FOR CONTROL

Daily Cash Report

Daily Treasury Report

Monthly Cash Report

CASH COLLECTION AND

DISBURSEMENT
Float
Speeding up Collections
Delaying Payments
EDI : Will the Float Disappear

FLOAT
The cash balance shown by a firm on its
books is called the book, or ledger,
balance whereas the balance shown in its
bank account is called the available, or
collected, balance. The difference between
the available balance and the ledger
balance is referred to as float.

There are two kinds of float viz.,

disbursement float and payment float

OPTIMAL CASH BALANCE

Total costs
Opportunity cost
Costs

C*

Transaction cost

Cash balance

INVESTMENT OF SURPLUS
FUNDS
A firms short-term investment
portfolio can be divided into
Ready cash segment
Controllable cash segment
Free cash segment

CRITERIA FOR EVALUATING

INVESTMENT OPTIONS
Safety
Liquidity
Yield
Maturity

INVESTMENT OPTIONS
Fixed deposits with banks
Treasury bills
Mutual fund schemes
Money market schemes
Commercial paper
Certificates of deposit
Inter-corporate deposits
Bill discounting

CASH MANAGEMENT MODELS

Several cash management models
have addressed this issue of split
between marketable securities and
cash holdings.
Two such models are :
Baumol model
Miller and Orr model

The Baumol Model

F = The fixed cost of selling securities to raise
cash
T = The total amount of new cash needed
K = The opportunity cost of holding
cash:with
thisRs
is
If we start
the interest rate.
C, spend at a
constant rate each
C
period and replace
our cash with Rs C
when we run out of
C
C
cash, our average
2
2
cash balance will
be
. And
1

Tim
3
e

Cost will be C/2 X K

The Baumol Model

C
T
Total cost K F
2
C

C
K
2

Opportunity
Costs

Trading
F
C
costs
*
C
Size of cash
balance
The optimal cash balance
is found where the
opportunity costs equal the trading costs
2T
*
C
F
K

The Baumol Model

The optimal cash balance is found where the
opportunity costs equal the trading costs
Opportunity Costs = Trading
Costs

C
T
K F
2
C

Multiply both sides by C

C2
K T F
2
2TF
C
K
*

TF
C 2
K
2

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 H cash is invested elsewhere to get us to
the target cash balance Z.
H

When the cash

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

The Miller-Orr Model Math

Given

L, which is set by the firm, the

Miller-Orr model solves for Z and H
2

3F
Z
L
4K
*

H 3Z 2 L
*

where 2 is the variance of net daily cash

flows.
The average cash balance in the MillerOrr model is
4Z * L
Average cash balance
3

Implications of 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.

The model clarifies the issues of cash

management:

The best return point, Z, is positively related to

trading costs, F, and negatively related to the
interest rate K.
. Z and the average cash balance are positively
related to the variability of cash flows.