Module 6 Notes
Module 6 Notes
Cash Management – Forecasting cash flows – Cash budgets, long-term cash forecasting,
monitoring collections and receivables, optimal cash balances – Baumol model, Miller-Orr
model, Strategies for managing surplus fund. (Theory and Problems)
Introduction
Cash management as the word suggests is the optimum utilization of cash to ensure maximum
liquidity and maximum profitability. It refers to the proper collection, disbursement, and
investment of cash.
For a small business, proper utilization of cash ensures solvency. Hence, cash management is
a vital business function; it is a function that manages the collection and utilization of cash.
Definition:
Cash Management refers to the collection, handling, control and investment of the
organizational cash and cash equivalents, to ensure optimum utilization of the firm’s liquid
resources. Money is the lifeline of the business, and therefore it is essential to maintain a sound
cash flow position in the organization.
On the other hand, if the firm makes purchases on cash basis but sells its products to customers
on credit terms, larger cash balance will have to be maintained.
Nature of Demand of Goods
If there is a steady demand of product in the market i.e. products of day to day requirement
(necessary items) and the product is sold for cash or for short credit period, firm will need low
level of cash. On the contrary, firm’s engaged in the production of luxury items have to
maintain high level of cash.
Inventory Policy
If high level of inventory is maintained by the firm, large amount is required for this, while if
a firm follows just in time inventory system, it need not to maintain large cash funds.
Production Process
Longer the production process, higher the requirement of cash balance but if production
process is short, the need of maintaining cash balance will be low.
Management Policy
Cash balance held by a firm also depends upon management policies and attitude towards the
liquidity preference, risk bearing capacity, sales and purchases policy, quantity of investment
and inventory etc. If the owners and managers of the firm want strict plans of cash management,
it can work with lower cash balance otherwise high balance will be required.
Matching of Cash Inflows and Outflows
The extent of non-synchronization between cash inflow and outflow determines the
requirement of cash . Higher the degree of variance between cash collection and disbursement,
higher will be the requirement of cash and vice versa.
The firm’s needs for cash may be attributed to the following needs: Transactions motive,
Precautionary motive and Speculative motive. Some people are of the view that a business
requires cash only for the first two motives while others feel that speculative motive also
remains.
1. Transaction Motive:
A firm needs cash for making transactions in the day to day operations. The cash is needed to
make purchases, pay expenses, taxes, dividend, etc. The cash needs arise due to the fact that
there is no complete synchronization between cash receipts and payments. Sometimes cash
The transaction needs of cash can be anticipated because the expected payments in near future
can be estimated. The receipts in future may also be anticipated but the things do not happen
as desired. If more cash is needed for payments than receipts, it may be raised through bank
overdraft.
On the other hand if there are more cash receipts than payments, it may be spent on marketable
securities. The maturity of securities may be adjusted to the payments in future such as interest
2. Precautionary Motive:
A firm is required to keep cash for meeting various contingencies. Though cash inflows and
cash outflows are anticipated but there may be variations in these estimates. For example, a
debtor who was to pay after 7 days may inform of his inability to pay; on the other hand a
supplier who used to give credit for 15 days may not have the stock to supply or he may not be
In these situations cash receipts will be less than expected and cash payments will be more as
purchases may have to be made for cash instead of credit. Such contingencies often arise in a
business. A firm should keep some cash for such contingencies or it should be in a position to
The cash maintained for contingency needs is not productive or it remains ideal. However, such
cash may be invested in short-period or low-risk marketable securities which may provide cash
3. Speculative Motive:
The speculative motive relates to holding of cash for investing in profitable opportunities as
and when they arise. Such opportunities do not come in a regular manner. These opportunities
cannot be scientifically predicted but only conjectures can be made about their occurrence.
For example, the prices of shares and securities may be low at a time with an expectation that
these will go up shortly. The prices of raw materials may fall temporarily and a firm may like
Such opportunities can be availed of if a firm has cash balance with it. These transactions are
speculative because prices may not move in a direction in which we suppose them to move.
The primary motive of a firm is not to indulge in speculative transactions but such investments
Such excess can be anticipated and properly invested if cash planning is resorted to. Similarly,
cash poor position can be corrected if the cash needs are planned in advance.
Thus, cash planning is a technique to plan and control the use of cash. This may be done on
daily, weekly or monthly basis depending upon the size of the firm and policies of management.
Cash budget is the most significant tool for cash planning and control.
• Cash Budget:
A firm should hold adequate cash balances but should avoid excessive balances. The firms has
therefore to assess its need for cash properly. “A cash budget is a statement showing anticipated
cash inflow, outflow and net cash balance for a future period of time”.
Cash budget is an important device to forecast the predictable discrepancies between cash
inflows and outflows over a projected time period. It is a summary statement which shows the
estimated cash inflows and cash outflows over the firms planning horizon.
The time period for which cash budget can be prepared depends upon the following points
• It also helps to pinpoint period(s) when there is likely to be excess cash to take
advantage like cash discounts on its accounts payable, capital expenditure decision
etc.
With advance planning through cash budget firms get adequate time to take the necessary
action for borrowing and lending of cash on the terms which are most advantageous to the firm.
In the words of Van Horne, “Optimising cash availability involves accelerating collections as
much as possible and delaying payments as long as is realistically possible”. The methods used
for accelerating the collections and decelerating disbursements are as follows –
can conserve cash and reduce its requirements for cash balances if it can speed up
its cash collections by issuing invoices quickly or by reducing the time lag between
a customer pays bill and the cheque is collected and funds become available for the
firm’s use i.e. first of all customers should be encouraged to make the payments as
early as possible and secondly efforts should be made to quickly process and collect
the cheques and drafts deposited by the customers.
There are basically three types of floats that create the difference
• Mail Float: The time gap between the postage of cheques / drafts by the debtors
and the receipt of the same in the firm is called mail or postal float.
• Processing Float: Time taken in processing the cheque within the firm before they
are deposited in the bank due to lethargy of employees is termed as processing float.
• Collection Float: The time difference between the cheque is deposited into the
bank and its actual realisation is called collection float.
Decentralised collection systems known as concentration banking and lock box systems can
help us to speed up collection of cash and in reducing the time involved in these floats
considerably.
• Concentration Banking: A large firm operating over wide geographical areas can
speed up its collection by following a decentralised collection procedure.
• Concentration banking is one important and popular way of reducing the size of
the float as it helps in:
• Lock Box System: Lock-box system is another step in expediting collection of cash.
Lock-Box is a post office box maintained by a firm’s bank that is used as a receiving
point for customer remittance.
Collection centre and its actual depositing in the local bank account. Under lock-box
system, the firm hires a post-office box and instructs its customers to mail their
remittances to the box.
• Minimum Number of Bank Accounts: Sometimes a firm may have more bank
accounts and we know it is the policy of banks to have some specified minimum
balance in the account, resulting blocking of some part of the cash in each such
account.
• Centralised Disbursement Centre: The firm should follow the centralised system
for disbursements as against decentralised system for collections. Under centralised
system, as all payments are made from a single control account, there will be delay in
presentation of cheques for payment by parties who are away from the place of
control account.
• Avoidance of Early Payments: According to the terms of credit, some credit period
is allowed to the buyers. The finance manager should try to control over the timing of
payments so as to ensure that bills are paid only as they become due.
• Playing the Float: It is a technical process by which a firm can make maximum
utilisation of cash. Float means the amount blocked in cheques issued but yet to be
collected and encashed. In other words, float is the difference between the balance
shown in firm’s cash book (bank column) and balance in the pass book of the bank.
The difference between the total amount of cheques drawn on a bank account and the
balance shown on the bank’s book is caused by transit and processing delay.
For example, If the party is at some distant station then cheque will come through post
and it may take a longer period before it is presented.
If the finance manager can accurately estimate when the cheque issued will be
deposited and collected, he can invest the ‘float’ during the float period to earn a
return. However playing the float should not result into loss of credit worthiness of
the firm.
3. Determination of Optimum Level of Cash
A business firm maintains the optimum cash balance for transaction and precautionary motives.
This amount will depend on risk return trade off. When the firm runs out of cash or it has low
liquidity, then it will have either to sell short-term securities or borrow cash. In both these
situations, the firm has to bear transaction cost.
On the contrary, if firm maintains high level of cash balance, the opportunity to earn interest is
lost. So, the potential interest lost on holding large cash balance involves opportunity cost to
the firm. The optimal level of cash is determined by the trade-off between transaction cost and
opportunity cost
It is clear from the above diagram that if the firm maintains large cash balances, its transaction
cost will decline but opportunity cost will increase or vice-versa. At point P the sum of the two
costs i.e. total cost is the minimum. This is the point of optimal cash balance which a firm
should seek to achieve.
1. Do Nothing
4. Develop Guidelines
Baumol’s Model
Baumol’s model, suggested by William J. Baumol, considers cash management similar to an
inventory management problem. It is a formal approach in determining a firm’s optimum cash
balance under certainty. According to this model, optimum cash level is that level of cash where
the carrying costs and transactions costs are the minimum.
The carrying cost refers to the cost of holding cash (opportunity cost) namely, the interest
foregone on marketable securities. The transaction cost refers to the cost involved in getting
the marketable securities converted into cash. It can be understood by following diagram :
For preparing the above diagram it is assumed that the demand of cash is steady for a given
period of time. During this period the firm can recover cash after selling the investments.
Suppose opening cash balance with firm is C and as and when this balance is spent on various
expenses, the firm sells the investment hence when cash balance becomes zero, the funds are
transferred from investment to cash.
This optimum cash balance according to this model will be at that point, where these two costs
are minimum.
Miller-Orr Model
Miller-Orr (MO) Model helps in determining the optimum level of cash when the demand for
cash is not steady and cannot be known in advance. MO model deals with cash
management problem under the assumption of random cash flows by laying down control
limits for cash balances.
Limitation of Miller-Orr Model
• Upper limit
• lower limit
• return point.
Setting of the control limits depend upon the fixed cost associated with a securities transaction,
the opportunity cost of holding cash and the degree of likely fluctuations in cash balances.
These limits satisfy the demands for cash at the lowest possible cost. The MO Model is more
realistic as it allows variations in cash balance within lower and upper limits.
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