CASH MANAGEMENT

Prabhjot Singh Longia Prince KaushalPuneet Walia Shubhpreet Kaur

LMTSOM THAPAR UNIVERSITY

WHAT IS CASH?

• In narrow sense: currency and generally accepted equivalents of cash like cheques, drafts etc.

• In broad sense: includes near-cash assets, such as marketable securities and time deposits in banks.– They can be readily sold and converted into cash.– Can serve as a reserve pool of liquidity.– Also provide short term investment outlet for excess cash.

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

Four Facets of Cash Management

• Cash planning

• Managing the cash flows

• Optimum cash level

• Investing surplus cash

Motives for holding cash

• Transaction motive

• Precautionary motive

• Speculative motive

• compensating motive

Transaction motive

• Holding of cash to meet routine cash requirements to finance the transactions which a firm carries on in the ordinary course of business.

Precautionary motive• The cash balances held in reserve for random and

unforeseen fluctuations in cash flows.• A cushion to meet unexpected contingencies.

– Floods, strikes and failure of imp customers– Unexpected slowdown in collection of accounts

receivable– Sharp increase in cost of raw materials– Cancellation of some order of goods

• Defensive in nature

Speculative motive

• Is a motive for holding cash/near-cash to quickly take advantage of opportunities typically outside the normal course of business.

• Positive and aggressive approach• Helps to take advantage of:

– An opportunity to purchase raw materials at reduced price– Make purchase at favorable prices– Delay purchase on anticipation of decline in prices– Buying securities when interest rate is expected to decline

Compensating motive

• Is a motive for holding cash/near-cash to compensate banks for providing certain services or loans.

• Clients are supposed to maintain a minimum balance of cash at the bank which they cannot use themselves.

Objectives of cash management• Meeting payments schedule

– It prevents insolvency– relationship with bank is not constrained– Helps in fostering good relationships– Cash discount can be availed– Strong credit rating– Take advantage of business opportunities– Can meet unanticipated cash expenditure with a minimum

of strain.• Minimizing funds committed to cash balances

– High level of cash: large funds remain idle– Low level of cash: failure to meet payment schedule

Managing Cash Collections and Disbursements

• Accelerating Cash Collections• Controlling Disbursements

Accelerating Cash Collections

1. Decentralised Collections

number of collection centres Collection centres will collect cheques from customers and

deposit in their local bank accounts They will deposit the funds to a central bank

Accelerating Cash Collections Contd…….

2. Lock-box System– Collection centers are established considering the customer locations

and volume of remittances– At each centre the firm hires a post office box – Remittances are directly picked from the bank whom the firm gives

the authority

Advantages of lock-box system are– cheques are deposited immediately upon receipt of remittances– Eliminates the period between the time cheques are received by the

firm and the time they are deposited in the bank for collection

Controlling Disbursements

It means delay the payments as much as possible. Can help the firm in conserving cash and reducing the financial requirements.

Disbursement or Payment Float

The size of the minimum cash balance depends on:

• How quickly and cheaply a organization can raise cash when needed.

• How accurately managers can predict cash requirements. Cash budget helps in this .

• How much precautionary cash the managers need for emergencies.

The organization’s maximum cash balance depends on:

• Availability of (short-term) investment opportunities– e.g. money market funds, CDs, commercial paper

• Expected return on investment opportunities.– e.g. If expected returns are high, organizations should be

quick to invest excess cash

• Transaction cost of withdrawing cash and making an investment

• Demand for Cash for daily transactions

BAUMOL MODEL Bumol recognized the similarities between cash and

inventory management. He extended the economic order quantity (EOQ) model to examine its implications to cash management. The Baumol model assumes the cash manager invests excess funds in interest bearing securities and liquidates them to meet the firm’s demand for cash. As investment returns increase, the opportunity cost of holding cash increases and the cash manager decreases cash balances. As transaction costs (cost of liquidating short-term investments) increase, the cash manager decreases the number of times he liquidates securities, leading to higher cash balances.

It has certain assumptions as follows

(a)The firm can predict its future cash requirements with certainty.

(b) The cash disbursements (outflow payments) are spread uniformly over the period.

(c) The interest rate (which is the opportunity cost of holding cash) is fixed.

(d) The firm will pay a fixed transactions cost each time it converts marketable securities into cash.

• 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 (i), then the firm’s holding cost for maintaining an average cash balance is as follows:

• 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 b, then the total transaction cost will be:

• The total annual cost of the demand for cash will be:

• The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for the optimum cash balance is as follows:

Explanation

Holding Cost = i*C/2

Transactional cost= b*T/C

Total Cost = i*C/2 + b*T/C

C=SQRT (2b*T/i)

Optimum Cash Balance under Certainty: Baumol’s Model

GRAPHICAL REPRESENTATION

EXAMPLE to clarify Baumol’s Model• JAYSHREE CHEMICAL Limited estimates its total cash requirement as Rs 4 crore next year.

The company’s opportunity cost of funds is 15% per annum. The company will have to incur Rs 300 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?

OPTIMUM CASH BALANCE = SQRT (2bT/i)= SQRT (2*300*4,00,00,000/0.15)=4,00,000 rs

Annual cost = Holding cost + Transaction cost

Holding cost = i*C/2 = 0.15* 4,00,000/2 = 30,000

Transaction cost = b*T/C = 300 * 4,00,00,000/4,00,000 = 30,000

TOTAL COST = 30,000+30,000 = Rs. 60,000

NUMBER OF DEPOSITS TO BE MADE IN A YEAR = T/C = 4,00,00,000/4,00,000 = 100

limitations of the Baumol model

Assumes a constant disbursement rate Ignores cash receipts during the period Doesn't allow for safety cash reserves

Miller-Orr ModelAllows Daily Cash Flow Variation

Provides two control limits1)Upper Control Limit2)Lower Control Limit & Return Point

The Difference depends upon1) The Transaction Cost (c)2) The Interest Rate (i)3) The Standard Deviation of net cash flow (σ)

Formulae

(Upper limit- Lower Limit)=( 3/4 x transaction cost X variance of cash flows )1/3 interest rate

Symbolically (Z)= ( 3/4 x cσ /i² )1/3

Upper Limit= Lower Limit + 3ZReturn Point= Lower Limit + Z

Average Cash Balance = Lower Limit +4/3 Z

Example• Xyz Company has a policy of maintaining cash balance of Rs. 5,00,000.

The Standard deviation of company’s daily cash flow is Rs 2,00,000. The Annual Interest Rate is 14%. Transaction cost of buying or selling is Rs. 150 per transaction.

• (Z)= ( 3/4 x 150x2,00,000²) 1/3 = Rs 2,27,227 .14/365

Upper limit =Lower limit +3Z=5,00,000+3(2,27,227)= Rs 11,81,680

Return Point=Lower limit +Z=5,00,000+2,27,227= Rs 7,27,227

Av. Cash Balance =Lower limit +4/3Z =5,00,000+4/3(2,27,227)= Rs 802,969

Investing Surplus Cash in Marketable Securities

• Selecting Investment Opportunities:– Safety– Maturity– Marketability

Thank You