Advanced Financial Management 20MBAFM306

Module-6 Cash Management 9 hours

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.

Objectives of Cash Management

• Fulfil Working Capital Requirement: The organization needs to maintain

ample liquid cash to meet its routine expenses which possible only through
effective cash management.
• Planning Capital Expenditure: It helps in planning the capital expenditure and
determining the ratio of debt and equity to acquire finance for this purpose.
• Handling Unorganized Costs: There are times when the company encounters
unexpected circumstances like the breakdown of machinery. These are
unforeseen expenses to cope up with; cash surplus is a lifesaver in such
conditions.
• Initiates Investment: The other aim of cash management is to invest the idle
funds in the right opportunity and the correct proportion.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

• Better Utilization of Funds: It ensures the optimum utilization of the available

funds by creating a proper balance between the cash in hand and investment.
• Avoiding Insolvency: If the business does not plan for efficient cash
management, the situation of insolvency may arise. It is either due to lack of
liquid cash or not making a profit out of the money available.

Factors Affecting the Cash Requirement

A firm must have so much of cash balance, that daily requirements and unexpected demands
can be met out. The factors affecting cash requirements and their effect on cash management
are as follows:

1. Credit Position of the Firm

2. Relation With Banks
3. Terms of Purchase and Sale
4. Nature of Demand of Goods
5. Inventory Policy
6. Production Process
7. Collection Period of Receivables
8. Management Policy
9. Matching of Cash Inflows and Outflows
Credit Position of the Firm
Firms with good and sound credit standing and goodwill need not to maintain separate cash for
unforeseen situations, as cash is available to such firms whenever needed. They can get liberal
credit facilities to purchase necessary material. On the contrary, firms with bad credit position
shall have to maintain high level of cash balance.

Relation With Banks

If firm has good relation with banks, it can get the facility of cash credit and bank overdraft
resulting less requirement of maintaining cash balance.

Terms of Purchase and Sale

Terms of purchase and sale also affect the level of cash balance. If a firm has facilities to buy
material on credit terms but sells its products on cash, it can operate its business affairs with a
little cash balance.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

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.

Collection Period of Receivables

If, in a firm, speed of collection of accounts receivable is quick, the cash will be available at
all time, bad debts will be lower and, the firm is not required to carry large cash balance.
However, if collection period is large, high balance will have to be maintained.

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.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

Motives for Holding Cash:

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

receipts exceed cash payments or vice-versa.

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

payment, dividend payment, etc.

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 a position to give credit at present.

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

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

business. A firm should keep some cash for such contingencies or it should be in a position to

raise finances at a short period.

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

as and when necessary.

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

to make purchases at these prices.

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

may be made at times.

Functions of Cash Management

Management of cash is an important function of the finance manager. He should formulate
strategies for the following areas:

1. Cash planning and Control

2. Management of Cash Inflows and Outflows
3. Determination of Optimum Level of Cash
4. Optimum investment of surplus cash

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

1. Cash planning and Control

Cash planning is a process of predicting cash inflows and cash outflows of the firm so as to
determine surplus or shortage of cash. At times, a firm can have idle cash with it if its cash
inflows are more than its outflows.

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

• Impact of seasonal variations on cash flows

• Degree and pattern of fluctuations in cash flows
• Preciseness in prediction of cash flows.
A Cash Budget has the following benefits:
• It coordinates the timings of cash needs. It identifies the period(s) when there might
either be a shortage of cash or remain an abnormally large balance.

• 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.

• Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage

of cash) on favorable terms.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

There are three methods to prepare the cash budget:

• Receipt and Payment Method
• Adjusted Profit and Loss Account Method
• Projected Balance Sheet Method
For short term (monthly, weekly, quarterly) cash budget, receipt and payment method is used
while for long term cash budget other methods can be used.

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.

• Cash Flow Analysis: A simple definition of a cash flow statement is – ‘a

statement which discloses the causes of changes in cash position between the two
periods’.
As per ICWAI, “Cash flow statement is a statement setting out the flow of cash
under different heads of sources and their utilizations to determine the requirements
of cash during the given period and to prepare for its adequate provisions”.
Thus along with changes in the cash position the cash flow statement also outlines
the reasons for such inflows or outflows of cash which in turn helps to analyze the
functioning of the business.
Cash flow analysis is based on historical data while cash budget is a technique for
future estimation. Ratio Analysis: Ratios like cash turnover ratio, cash flow coverage
ratio, cash payment ratio are also important techniques of cash planning and control.
2. Management of Cash Inflows and Outflows
After knowing the cash position with the help of cash budget, the management should work
out the basic strategies to be employed to manage its cash flows. So that there does not exist a
significant deviation between projected cash flows and actual cash flows.

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 –

• Accelerating Cash Collections: In order to accelerate cash inflows, the collection

from customers should be prompt. The finance manager has to devise action not
only to fraudulent diversion of cash but also to speed up collection of cash. A firm

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

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.

In concentration banking the company establishes a number of strategic collection

centres in different regions instead of a single collection centre at the head office.
Payments received by the different collection centres are deposited with their
respective local banks which in turn transfer all surplus funds to the concentration
bank of head office.

• Concentration banking is one important and popular way of reducing the size of
the float as it helps in:

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

• Reduction of Mailing Time: Under the system of concentration banking, as the

collection centres themselves collect cheques from the customers and immediately
deposit them in local bank account, the mailing time is reduced. If collection centres
are allowed to send bills to the customers of their respective areas, the time required
for mailing is less than the bills are mailed from the head office.

• Reduction of Time Required to Collect Cheques: As the cheques deposited in the

local bank accounts are usually drawn on banks in that area, the average collection
period also comes down.

• Expediting Collection of Cash: The system of concentration banking also helps in

quicker collection of cash as it reduces the size of deposit float.

• 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.

• Slowing Disbursement: The operating cash requirement can be reduced by slow

disbursement of accounts payables. Slow disbursements represent a source of
funds requiring no interest payments. But this should not impair the credit rating or
reputation of the firm.

There are several techniques to delay payment of accounts payable.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

Some of important method are as below:

• 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.

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

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.

4. Optimum investment of surplus cash

Cash kept by the firm in excess of its normal need is called the surplus cash. Due to changing
working capital needs or unpredictable requirements the finance manager is required to
consider the minimum cash balance that the firm should keep to avoid the cost of running out
of funds.

Strategies for managing Surplus Cash

1. Do Nothing

2. Make Ad hoc Investments

3. Ride the yield curve

4. Develop Guidelines

5. Utilize Control Limits

6. Managing with a portfolio perspective

7. Follow a Mechanical Procedures

Cash Management Models

To help in determining optimum cash balance, several types of cash management models have
been designed. Out of such models, two of them are:
• Baumol’s Model, i.e., optimum cash balance under certainty,
• Miller-Orr Model i.e., Optimum cash balance under uncertainty are quite popular.
Cash Management Models

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

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.

The Baumol’s model has the following assumptions:

• The firm can forecast its cash requirement with certainty.
• Cash disbursement will be steady during a given period.
• The sequence of cash receipt and disbursement will continue to be the same.
• Whenever the firm converts its securities into cash, its transaction cost will be the
same.
• The firm’s opportunity cost of holding cash is known and it is the same over time.
Limitation of Baumol’s Model
The assumptions do not fit in practical environment. Practically cash disbursements are found
to be variable and uncertain and variance will be there in cash receipts and disbursements
during each month or days in a month. Transaction and opportunity cost also varies over time.

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

Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24

 Advanced Financial Management 20MBAFM306

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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Prof. Rajimol K P, MBA Dept, Atria IT, Bangalore-24