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Cash management
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Introduction
Cash management is one of the key areas of workingcapital management.
Apart from the fact that it is the most liquid current asset,cash is the common denominator to which all currentassets can be reduced because the other major liquidasset, that is, receivables and inventory get eventuallyconverted into cash.
This underlines the significance of cash management.
Cash is the ready currency to which all liquid assets canbe reduced.
Near cash implies marketable securities viewed the wayas cash because of their high liquidity.
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Motives for holding cash
Transaction motive
Precautionary motives
Speculative motives Compensating motives
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Transaction motive
An important reason for maintaining cash balances is thetransaction motive.
This refers to holding of cash to meet routine cashrequirements to finance the transaction which a firm
carries on in the ordinary course of business. For example, cash payment have to be made for
purchases, wages, operating expenses, financialcharges like interest, taxes, dividends and so on.
If the receipt of cash and its disbursements could exactly
coincide in the normal course of operations, a firm wouldnot need cash for transaction purposes.
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Precautionary motives
In addition to the non-synchronization of anticipated cashinflows and outflows in the ordinary course of business,a firm may have to pay cash for purpose which cannotbe predicted or anticipated.
The unexpected cash need at short notice may be the
result of: Floods, strike and failure of important customers; Bills may be presented for settlement earlier than
expected. Unexpected slow down in collection of accounts
receivable Cancellation of some orders for good as the customer is
not satisfied And sharp increase in cost of raw materials
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Contd
The cash balance held in reserve for such random and
unforeseen fluctuations in cash flow are called
precautionary balances.
Thus precautionary cash balance serves to provide acushion to meet unexpected contingencies.
Such cash balance are usually held in the form of
marketable securities so that they earn a return.
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Speculative motives
It refers to the desire of a firm to take advantage of
opportunities which presents themselves at unexpected
moments and which are typically outside the normal
course of business. The speculative motive represents a positive and
aggressive approach
Firms aim to exploit profitable opportunities and keep
cash in reserve to do so.
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Contd
The speculative motive helps to take advantage of :
An opportunity to purchase raw materials at a reduced
price on payment of immediate cash
A chance to speculate on interest rate movements bybuying securities when interest rates are expected to
decline.
Delay purchases of raw materials on the anticipation of
decline in prices Make purchases at favorable prices
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Compensating motives
y Yet another motive to hold cash balances is to compensatebanks for providing certain services and loans.
y Banks provide a variety of services to business firms, such asclearance of cheque, supply of credit information, transfer of
funds, and so on.y While for some of these services bank charges a commission
or fees, for other they seek indirect compensation.
y Usually clients are required to maintain a minimum balance ofcash at the bank.
y Since this balance cannot be utilized by the firms fortransaction purposes, the banks themselves can use theamount to earn a return. Such balances are compensatingbalances
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Contd
The compensating cash balances can take eitherof two forms
(i) an absolute minimum, say, Rs 5 lakhs below
which the actual bank balance will never fall (ii) a minimum average balance, say, Rs 5 lakh
over the month
Of the four primary motives of holding cashbalances the two most important are thetransaction motives and compensation motives.
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Objectives of cash
management Meeting payment schedules
Minimizing funds committed to cash
balance.
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Factors determining cash
needsySynchronization of cash flows
yShort costs
y (i) transaction costs
y (ii) borrowing costs
y (iii) loss of cash-discount
y (iv) cost associated with deterioration of
the credit ratingy (v) penalty rates
yExcess cash balance cost
yProcurement and management
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Baumol model
The Baumol model of cash management provides aformal approach for determining a firms optimum cashbalance under certainty.
It considers cash management similar to an inventory
management problem.
The purpose of this model is to determine the minimumcost amount of cash that a financial manager can obtainby converting securities to cash, considering the cost ofconversion and counter-balancing cost of keeping idlecash balances which otherwise could have beeninvested in marketable securities
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Contd
The total cost associated with cash management,
according to this model has two elements:
(i) cost of converting marketable securities into cash and
(ii) the lost opportunity cost. The baumols model makes the following
assumptions:
The firm is able to forecast its cash needs with certainty.
The firms cash payments occur uniformly over a periodof time.
The opportunity cost of holding cash is known and it
does not change over time.
The firm will incur same transaction cost whenever itconverts securities to cash.
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Contd
Let us assume that the firm sells securities and startswith a cash balance of C rupees. As the firm spendscash, its cash balance decreases steadily and reachesto zero. The firm replenishes its cash balance to C
rupees by selling marketable securities. This pattern continues over time. Since the cash balance
decreases steadily the average cash balance will be :
C/2.
This pattern is shown below
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Contd
Cash balance
Time
Average
C
C/2
T1 T2 T30
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Contd
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 firms holdingcost for maintaining an average cash balance is
as follows:
Holding cost or opportunity cost = i(C/2)
Where i= interest rate that could have been
earned
C/2= the average cash balance that is, the
beginning cash (C) plus the ending cash
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Contd
The firm incurs a transaction cost whenever itconverts its marketable securities to cash. Totalnumber of transactions during the year will be
total funds requirements, T, divided by the cashbalance, C, i.e. T/C. the per transaction cost isassumed to be constant. If per transaction costis b then total transaction cost will be:
transaction cost or total conversion cost perperiod = b(T/C)
Where b= cost per conversion
T= total transaction cash needs for the period
C= value of marketable securities sold at each
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Contd
The total annual cost of demand for cash will
comprise of total conversion cost plus
opportunity cost symbolically it can be
expressed as i (C/2) +(b)(T/C)
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Contd
To minimize the cost, therefore, the model
attempts to determine the conversion amount
that is the cash withdrawal which costs the least.
The optimum cash balance is obtained when thetotal cost is minimum
C= 2bt
i
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Contd
Cash BalanceCash Balance
AnnualAnnualcostcost
Slope = 0Slope = 0
MinimumMinimumtotal costtotal cost
Total CostTotal Cost
Transaction Cost =Transaction Cost =TbTb
CC
Opportunity Cost =Opportunity Cost =iCiC
22
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Miller-Orr model
The limitation of boumol model is that it
dose not allow the cash flow to fluctuate.
Firm in practice do not use their cash
balance uniformly nor they are able to
predict daily cash inflows and outflows.
The miller Orr model overcomes this
shortcomings and allows for daily cashflow variation .
Miller Orr assumes that the changes in
cash balance over a given period are
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Time
The Miller - Orr Model
Lower Limit
Upper Limit
Z orReturn poin
Sell Securities
Buy SecuritiesUL
LL
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Contd
If the firms cash flows fluctuate randomly
and hit the upper limit, then it buys
sufficient marketable securities to come
back to the normal level of cash(the return
point ) similarly when the firms cash flow
wander and hit the lower limit it sells
sufficient marketable securities to bring thecash level back to the normal level.
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Contd
While the value of lower control limit (LL)
is set by the management based on what
it considers to be the minimum below
which the cash balance should not fall, the
values of RP and UL have been derived by
miller Orr with the view to minimizing the
total ordering and holding costs. The following are the results of the
analysis
RP =3 3b(s.d)2 + LL
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Control of cash collection and
disbursement.
The strategic aspect of efficient cash
management approach are:
speedy collection of accounts receivablesand
delaying the payments on accounts
payable.
Speedy cash collections: in managing
cash efficiently, the cash inflow process
can be accelerated through systematic
planning and refined techniques. There
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Prompt payment by
customer One way to ensure prompt payment bycustomer isprompt billing. What the
customer has to pay and the period of
payment should be notified accuretly and
in advance. The use of mechanical
devices for billing along with the enclosure
of a self-addressed return envelope willspeed up payment by customers.
Another, and more important, technique to
encourage prompt payment by customers,
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Early conversion of payments
into cash.
Once the customer makes the payment by writing a cheque inthe favor of the firm, the collection can be expedited by
prompt encashment of the cheque. There is a lag between thetime a cheque is prepared and mailed by the customer and thetime the funds are included in the cash reservoir of the firm.Within the time interval three steps are involved:
A) Transit or mailing time, that is, the time taken by the postoffices to transfer the cheque from the customer to the firmreferred to as postal float.
B) Time taken in processing the cheque within the firm before
they are deposited in the banks, termed as lethargy; C) collection time within the bank, this is called bank float.
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Contd
The early conversion of payment into cash, as a
technique to speed up collection of accounts
receivable, is done to reduce the time lag
between the posting of the cheque by thecustomer and the realization of money by the
firm. The postal float lethargy and the bank float
are collectively referred to as deposit float. The
term float is defined as the sum of chequewritten by customer that are not yet useable by
the firm.
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Contd
An important cash management technique
is reduction in deposit float.
This is possible if the firm adopts he policyof decentralised collections
The principal method of establishing
decentralized collection network are
Concentration banking
Lock-box system
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Concentration banking
Concentration banking is a system of
operating through a number of collection
centers, instead of a single collection
center centralized at the firms head office.
The basic objective of decentralized
collection is to minimize the lag between
the mailing time from customer to the firmunder this system the firm will have a large
number of bank accounts operated in the
areas where the firm has its branches.
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Contd
The collection centers will be required to
collect cheques from customers and
deposit it in their local bank accounts.
The collection center will transfer funds
above some predetermined minimum to a
central or concentration bank account. A
concentration bank is one where the firmhas a major account usually disbursement
account.
Funds can be transferred to a central or
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Lock-box system
Lock-box system another technique of
speeding up the mailing, processing time
and, collection time is lock-box system.
In concentration banking cheques are
received by a collection center and after
processing are deposited in the bank.
Lock-box system helps the firm to
eliminate the time between the receipts of
cheques and their deposit in the bank.
In a lock-box system, the firm establishes
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Contd
At each center, the firm hires a post office
box and instructs its customers to mail
their remittance in the box.
The firms local bank is given the authority
to pick-up the remittance directly from the
lock box.
The bank picks up the mails several times
a day and deposits the cheques in the
firms account.
For the internal accounting purpose of the
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Contd
Two main advantages are
1. The bank handles the remittance prior to
deposit at a lower cost.2. The cheques are deposited immediately
upon receipt of remittance and their
collection processes sooner than if the
firm would have processed them for
internal accounting purpose prior to their
deposits.
Both the systems involve cost. Whether
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Delaying payments on
accounts receivable
This can be done through:
Avoidance of early payments Centralized disbursement
Float
Paying from a distant bank Accruals
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Strategies for managing
surplus cash Do nothing: the financial manager simplyallows surplus liquidity to accumulate in
the current account. This strategy
enhances liquidity at the expense of profits
that could be earned from investing
surplus fund.
Make ad hoc investments: the financialmanager makes investments in some what
ad hoc (unplanned, unprepared) manner
such a strategy makes some contribution,
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Contd
Ride the yield curve: this is a strategy to
increase the yield from a portfolio of
marketable securities by betting on
interest rate changes.
If the financial manager expects that
interest rates will fall in the near future he
would buy longer term securities as theyappreciate more, compared to short term
securities.
On the other hand, if the financial manager
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Contd
Develop guidelines: a firm may develop a
set of guidelines which may reflect the
view of the management towards risk and
return.
Examples of such guidelines are:
(i) Do not speculate on interest rate
changes. (ii) Hold marketable securities till
they mature (iii) do not put more than a
certain percentage of liquid funds in a
particular security or instrument (iv)
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Contd
Utilize control limits: there are some
models of cash management which
assumes that cash inflow and outflow
occur randomly (irregular) over time.
Based on this premise, these models
define the upper and lower control limits.
When the cash balance touches the upper
limit, the model prescribes that a certain
amount should be invested in the
marketable securities and when the cash
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Contd
Manage with a portfolio perspective: according to the
portfolio theory there are two key steps in portfolio
selection.
D
efine the efficient frontier: the efficient frontierrepresents a collection of all efficient portfolios. A
portfolio is efficient if and only if there is no alternative
with (i) the same expected return and a lower standard
deviation, or (ii) the same standard deviation and a
higher expected return, or (iii) a high expected return anda lower standard deviation
Select the optimal portfolio: the optimal portfolio is that
point on the efficient frontier which enables the investor
to achieve the highest attainable level of utility.
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Stone model
The Stone Model is somewhat similar to
the Miller-OrrModel in so far as it uses
control limits.
It incorporates, however, a look-ahead
forecast of cash flows when an upper or
lower limit is hit to take into account the
possibility that the surplus or deficit ofcash may naturally correct itself.
If the upper control limit is reached, but is
to be followed by cash outflow days that
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Contd
Of course, if cash were in short supply and the lower
control limit was reached, the opposite would apply.
In this way the Stone Model takes into consideration the
cash flow forecast.
The goals of these models are
To ensure adequate amounts of cash on hand for bill
payments,
To minimize transaction costs in acquiring cash when
deficiencies exist,
And to dispose of cash when a surplus arises.
These models assume some cash flow pattern as a
given, leaving the task of cash collection, concentration,
and disbursement to other methods.
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Long term cash
forecasting Long term cash forecast are prepared togive an idea of the companies financial
requirements in distant future. They are
not as detailed as short term forecast.
Long term cash forecast can be made for
a period of two three or five years .
Once a company has developed long term
cash forecast it can be used to evaluate
the impact of say new product
developments or plant acquisitions on the
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Contd
The major uses of long term cash forecast
are:
I
t indicates as companys future financialneeds, especially for its working capital
requirements.
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.
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Short term cash forecast
It is comparatively easy to make short
term forecasts. The important functions of
carefully developed short-term cash
forecast are:
To determine operating cash requirement
To anticipate short term financing
To manage investment of surplus cash
Some more uses of these forecasts are:
Planning reduction of short and long term
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Contd
Two most commonly used methods of
short term cash forecasting are
The receipt and disbursement method The adjusted net income method
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Cash budget
Cash budget is a statement of the inflows
and outflows of cash that is used to
estimate its short term requirements.
The cash budget is probably the most
important tool in cash management it is a
device to help a firm to plan and control
the use of cash.
It is a statement showing the estimated
cash inflows and outflows over the
planning horizon