Cash Management

Significance of Cash
❖ Cash is one of the components of current assets.

❖ It is a medium of exchange for purpose of goods and services and for

discharging liabilities.

❖ Cash management is one of the key areas of working capital

management as cash is both beginning and the end of working
capital cycle - cash, inventories, receivables and cash.

❖ It is the most liquid asset and the basic input required to keep the
business running on a continuous basis.
 Nature of Cash

❖ In cash management, the term cash has been used in two senses:

❖ Narrow sense: Under this, cash covers currency and generally

accepted equivalents of cash, viz., cheques, demand drafts and bank
demand deposits.

❖ Broad sense: Here, cash includes not only the above, but also cash
assets. There are bank’s time deposits and marketable securities. The
marketable security can be easily sold and converted into cash. Here,
cash management is in a broader sense.
 Objectives of Cash Management

❖ To meet payment needs: The payments are like payment to supplier of raw
materials, payment of wages and salaries, payment of electricity bills, telephone
bills and so on. Firm should maintain cash balances to meet the payments,
otherwise it will not be able to run business. Cash is the business lubricant.

❖ To Maintain Minimum Cash Balance (Reserve): It means the firm should not
maintain excess cash balances. Excess cash balance may ensure prompt
payment, but if the excess balance will remain idle, as cash is a non-earning
asset and the firm will have to forego profits.

❖ Hence, the aim of cash management is to maintain optimum cash balance.

 Aspects of Cash Management

❖ The aspects or problems of cash management can be examined under

three heads, such as:
❑ Cash inflows and outflows,
❑ Cash flow within the firm, and
❑ Cash balances held at the point of time.
 Aspects of Cash Management

❖ Cash inflows (receipts) and outflows (payments) may not match, there
may be excess or less cash outflows.

❖ Surplus cash arise when the cash inflows are excess over cash
outflows and deficit will arise when the cash inflows are less than the
cash outflows.

❖ The firm should develop appropriate strategies for resolving the

uncertainty involved in cash flow prediction and in balance between
cash receipts and payments.
 Aspects of Cash Management

❖ Firm has to come up with some cash management strategies regarding

the following four facets of cash management:
❑ Cash Planning
❑ Cash flow Management
❑ Determination of optimum cash balance
❑ Investment of surplus cash
 Aspects of Cash Management

❖ Cash Planning - Cash planning is requited to estimate the cash

surplus or deficit for each planning period. Estimation of cash surplus or
deficit can be arrived by preparation of cash budget.

❖ Cash flow Management - The cash flows should be properly managed

that the cash inflows should be accelerated (collected as early as
possible) and cash outflows should be decelerated (cash payments
should be delayed without affecting firm’s name).
 Aspects of Cash Management

❖ Determination of Optimum Cash Balance: Optimum cash balance is

that balance at which the cost of excess cash and danger of cash
deficiency will match. In other words, it is the cash balance at which the
total cost (total cost equals to transaction cost and opportunity cost) is
minimum. Firm has to determine optimum cash balance.

❖ Investment of Surplus Cash: Whenever there is surplus cash it

should be properly invested in marketable securities, to earn profits.
Firms should not invest in long- term securities, as they cannot be
converted into cash within a short period.
 Factors determining Cash needs

❖ Synchronization of Cash Flows

❖ Short Costs
❑ Cost of Transaction
❑ Cost of borrowing
❑ Cost of Deterioration of Credit Rating
❑ Cost of Loss of Cash Discount
❑ Cost of Penalty Rates
❖ Surplus Cash Balance Costs
❖ Management Costs
 Factors determining Cash needs

❖ Synchronization of Cash Flows - Synchronization of cash flows

arises only when there is no balance between the expected cash
inflows and cash outflows. There is no need to manage cash balance, if
there is perfect match between cash inflows and cash outflows.
Otherwise, there is a need to manage cash balance for managing
synchronization. This synchronization is forecasted through the
preparation of cash budget for a period of 12 months or the planning
period. A well-prepared cash budget will definitely point out the months
or periods when the firm will have surplus or deficit cash.
 Factors determining Cash needs

❖ Short costs - This is another factor to be considered while determining

the cash needs. Short costs are those costs that arise with a short fall
of cash for the firm’s requirements. Shortage of cash can be found
through preparation of cash budget. Cash shortage is not cost free, it
involves cost whether it is expected or unexpected shortage. The
expenses incurred as a result of shortfall are called short costs.
 Factors determining Cash needs

❖ Short costs:
❑ Cost of Transaction - Whenever there is a shortage of cash it
should be financed. Financing may be done through borrowings
from banks or sale of marketable securities. If the firm is planning to
finance the deficit cash by sale of marketable securities, then the
firm is expected to spend some expenses for brokerage.

❑ Cost of Borrowing: If the firm does not have marketable securities

with it, then it prefers borrowing as a source of financing shortage of
cash. It involves costs like interest on loan, commitment charges
and other expenses relating to the loan.
 Factors determining Cash needs

❖ Short costs:
❑ Cost of Deterioration of Credit Rating - Generally credit rating is
given by credit rating agencies (CRISIL, ICRA and CARE). Low credit
rating firms may have to go for bank loans with high interest charges,
since they cannot raise the required amount from the public. Low
credit rating may also leads to the stoppage of supplies, demands for
cash payment, refusal to sell, loss of image and attendant decline in
sales and profits.

❑ Cost of Loss of Cash Discount: Sufficient cash helps to get cash

discount benefits, but shortage of cash cannot help to obtain cash
discounts.
 Factors determining Cash needs

❖ Short costs:
❑ Cost of Penalty Rates - Whenever there is shortage of cash, firm
may not be able to honor current obligations, which in turn involves
penalty.
 Factors determining Cash needs

❖ Surplus Cash Balance Costs - It means the cost associated with

excess or surplus cash balance. Cash is not an earning asset. Surplus
cash funds are idle, an impact of idle cash is that the firm losses
opportunities to invest those funds and thereby lose interest, which
would otherwise have been earned.

❖ Management Costs - Management costs are those costs involved with

setting up and operating cash management staff. These cost are
generally fixed over a period, and are mainly include staff salary,
storage, handling cost of security and so on.
 Cash Planning or Cash Budget

❖ Cash planning and control of cash is the central point of finance functions.

❖ Maintenance of adequate cash is one of the prime responsibilities of

finance manager. It is possible only through preparation of cash planning.

❖ Cash planning is a technique to plan and control the use of cash.

❖ A projected cash flow statement prepared based on expected cash

receipts and payments, is the anticipation of the financial condition of the
firm.
 Cash Budget – Illustration 1
Prepare a cash budget for the months of June & July from the following:

Credit
Credit Purchase Manufacturin Selling
Sales (Rs.) (Rs.) g O/H (Rs.) O/H (Rs.)
April 80000 60000 2000 3000
May 84000 64000 2400 2800
June 90000 66000 2600 2800
July 84000 64000 2000 2600
▪ Advance tax of Rs. 4000 payable in June & in December
▪ Credit period allowed to debtors is 2 months
▪ Credit period allowed by suppliers is 1 month
▪ Delay in payment of other expenses – 1 month
▪ Estimated opening cash balance (1st June) – Rs. 20000
 Cash Budget – Illustration 1
Particulars June (Rs.) July (Rs.)
Opening balance 20000 26800
Receipts:
Sales 80000 84000
Total Receipts (A) 100000 110800
Payments
Purchases 64000 66000
Manufacturing Overheads 2400 2600
Selling Overheads 2800 2800
Tax payable 4000 0
Total Payments (B) 73200 71400
Balance (A+B) 26800 39400
 Managing Cash Flows

❖ After estimation of cash flows, the financial manager’s next job is to

ensure that there is as little deviation between the projected cash flows
and the actual cash flows.

❖ Financial manager will have the control on collection of receipts and

cash disbursements.

❖ The objective of cash management is to accelerate cash receipts as

much as possible and decelerate or delay cash payments as much as
possible.
 Managing Cash Flows

❖ The idea is to speed up collection of accounts receivables, so that the

firm can use money sooner, otherwise, it has to borrow money, wherein
costs are involved.

❖ Conversely, firm wants to pay accounts payables late without affecting

credit standing with suppliers, so that firm can make use of the money it
already has.
 Accelerating Cash Collections

❖ Prompt payment by customers by offering cash discounts

❖ Early conversion of payments into cash by reducing Bank / Deposit

Float (time taken by the firm’s bank in collecting the cheque payment
from the buyer’s bank). It is possible through the options of
decentralized collection policy. There are two important methods
available to use in a decentralized collection network, they are
concentration banking and Lock-Box system.
 Accelerating Cash Collections

❖ Concentration Banking or Decentralized Collections: A firm

operating its business spread over a vast area and its branches located
at different places would do well to decentralize its collections.
Concentration banking is a system of operating through a number of
collection centers, instead of a single collection centre centralized at the
company’s head office premises. Under this system, a firm will have a
large number of bank accounts in the operated areas. Collection is
done locally. On realization of the proceeds of the cheques, these may
be remitted for credit to the Head Office Account. Hence, concentration
banking reduces float, which saves time and reduces in the operating
cash needs. This system should be adopted only when the savings are
higher than the cost.
 Accelerating Cash Collections

❖ Lock – Box System: This is another technique of accelerating

collection of cash. It is more popular in USA and European countries.
Under this arrangement, a firm rents a post office box and authorizes its
bank to pick up remittances in the box. The boxes will be placed at
different centers on the basis of number of consumers. Customers are
billed with instructions to mail remittances to the box. The local
authorized bank of the firm, at the respective places pick up the mail
several times a day and deposits the same into the firms account. After
the collection of cheques, the bank sends a deposit slip along with the
list of payments and other required encloses.
 Accelerating Cash Collections

❖ Advantages of Lock – Box System:

❑ The bank handles the remittances prior to deposit at a lower cost;
❑ The process of collection through the banking system begins
sooner compared to the receipt of cheque and hence saves time;

❖ Lock-box system involves cost, since the services provided by the bank
are chargeable or the firm is required to maintain a minimum cash
balance that involves an opportunity cost. A financial manager has to
compare the benefits derived from use of lock-box system and when
benefits are higher than the cost involved, it should be adopted.
 Slowing down Cash Payments

❖ Payment on last date

❖ Centralized payment increases the transit time.

 Paying the Float

❖ Float is the amount of money tied up in cheques that have been written,
but have yet to be collected.

❖ In simple words, float refers to the difference between the balance in

firms cash book (bank column) and balance in passbook of the bank.

❖ There is a time lag between issue of cheque by the company and its
presentation to the bank by its customer’s bank for collection of money,
so cash is required later at the time when the cheque is presented for
collection.
 Paying the Float

❖ So, firm can issue cheque without having sufficient cash in its bank
account at the time of its issue to its customers, but by the time of
presentation of the Cheque for encashment, firm must arrange funds.

❖ Use of float in this way referred to as cheque kiting.

❖ Cheque kiting can be done in two ways—(a) paying from a distant

bank and (b) cheque encashment analysis.
 Paying the Float – Cheque Encashment Analysis

❖ Cheque Encashment Analysis: On the basis of the firm’s past

experience (if firm has been paying for a few years now), it can find out
the lag in the issue of cheques and their encashment. If more time lag
is there, then the firm will pay with delay and vice versa. It will help the
firm to save cash.
 Computation of Optimum Cash Balance

❖ A firm has to maintain sufficient liquidity by managing minimum

cash balance.

❖ Maintenance of cash balance provides sufficient liquidity but involves

opportunity cost (loss of interest), whereas less cash balance
maintenance weakens liquidity and involves profitability.

❖ A firm has to maintain optimum cash balance. Now the question is, how
to determine optimum cash balance?
❑ Baumol Model (Inventory Model)
❑ Miller and Orr Model (Statistical Model)
 Baumol Model

❖ This model was developed by Baumol.

❖ It considers optimum cash balance similar to the economic order

quantity, since it is based on EOQ Concept.

❖ There is trade off between cost of borrowing (sale of securities cost)

and the opportunity cost.

❖ The point where the total cost is minimum is the optimum point.
 Assumptions of Baumol Model

❖ The firm knows its cash needs with certainty.

❖ The cash payments (disbursement) of the firm occur uniformly over a

period of time and is known with certainty.

❖ The opportunity cost of holding cash is known and it remains stable

over time.

❖ The transaction cost is known and remains stable.

 Baumol Model

❖ The cash payments are made evenly over the planning period. This
means that the cash balance of the firm behaves in the saw tooth
manner as shown in the figure below.

Cash

Time
 Baumol Model

❖ The total cost associated with management of cash under this model
involves two elements:
❑ Conversion cost (transaction cost)
❑ Opportunity cost (interest cost)
 Baumol Model

❖ Conversion Cost (Transaction cost): Conversion costs are those

costs that are associated with sale of marketable security and arise
whenever firm converts marketable security into cash. Conversion Cost
(C) = C [F/M], Where: F is the expected cash need for future period,
and M is the amount of marketable securities sold in each sale.

❖ Opportunity Cost: It is the cost of benefit foregone by holding idle

cash. In other words, opportunity cost is the interest forgone on
average cash balance. Symbolically, Opportunity cost (O) = I * (M / 2),
where I = Interest rate that could have been earned, and M / 2 =
Average cash balance [(Opening cash + Closing cash) / 2].
 Baumol Model

❖ Total cost = Conversion cost + Opportunity cost

 Baumol Model

❖ Economical (optimal) Conversion lot size:

❖ Where,
❑ ECL = Economic Conversion Lot;
❑ C = Cost per conversion;
❑ F = Expected cash needed for future period
❑ O = Opportunity cost
 Illustration - 2

❖ Estimated cash need of X Ltd. is Rs. 20 lakhs for a year. Cost of

transaction of marketable securities is Rs. 2000 per lot. The company
has marketable securities in lot sizes of Rs. 100000, Rs. 200000, Rs.
400000, Rs. 500000 and Rs. 1000000. Determine economic
conversion lot size if 20% is the opportunity cost.
 Illustration - 2

❖ ECL = (2 * 2000 * 2000000 / 0.2)0.5 = Rs. 200000

 Miller & Orr Model

❖ The Miller and On model is in fact an attempt to make Baumol model

more elastic with regards to the pattern of periodic changes in cash
balances.

❖ Baumol’s model is based on the assumption that uniform and certain

level of cash balances.

❖ But in practice firms do not use uniform cash balances nor are they
able to predict daily cash inflows and outflows.
 Miller & Orr Model

❖ The Miller Or Model overcomes the limitations of Baumol model.

❖ It is augmented on the Baumol Model and came out as a statistical

model. It is useful for the firms with uncertain cash flows.

❖ The Miller & Orr model provides two control limits—the upper control
limit and the lower control limit along with a return point.
Miller & Orr Model
 Miller & Orr Model

❖ According to this model, cash balance fluctuates between LCL and

UCL.

❖ Whenever, cash balance touches UCL then the firm purchases

sufficient (UCL - RP) marketable securities to take back cash balance
to return point.

❖ On the other hand when the firm touches the lower control limit, it will
sell the marketable securities to the extent of (RP - LCL), to take back
cash balance to return point.
 Miller & Orr Model

❖ The cash balance at the lower control limit (LCL) is set by the firm as
per requirement of maintaining minimum cash balance.

❖ The cash balances at upper control limit (UCL) and record points will be
determined on the basis of the transaction cost (C), the interest rate (O)
and standard deviation (s) of net cash flows.
 Miller & Orr Model

❖ The following formula is used to determine the spread between UCL and
LCL (called Z) as per Miller & Orr model:

❖ Where
❑ Z = Control limit of cash balance (or) return point
❑ C = Transaction cost
❑ σ = Standard Deviation of net cash flow
❑ LCL = Lower control limit
❑ O = Opportunity cost or interest rate earned on marketable security
 Investment of Surplus Funds

❖ Firms may have surplus (excess cash) funds on several occasions that
are required after sometime. Therefore, it would be an efficient decision,
if the excess cash is invested in some investment avenues that may be
safe and liquid, and which may even earn some reasonable interest too,
during the holding period.

❖ A number of marketable securities are available to the firm, depending

upon the varying degree of risks and liquidity and the matching income
generation.

❖ The financial manager must decide the portfolio of marketable securities

in which the firm’s excess cash (surplus funds) should be invested.
 Selecting the particular Investment option

❖ In selecting an investment avenue among available alternatives, the

firm has to examine four basis features:
❑ Safety
❑ Marketability
❑ Yield
❑ Maturity
Money Market Instruments / Marketable Securities

❖ Money market refers to the market for short-term securities.

❖ It has no physical market place and it consists of a loose agglomeration

of banks, financial institutions and dealers linked together by telex,
telephones and computers.

❖ A huge volume of securities is regularly traded on the market and the

competition is energetic.

❖ The prominent short-term securities available for investment of surplus

cash is shown in the subsequent slides.
 Treasury Bills (T – Bills)

❖ A treasury bill is basically an instrument of short term borrowing by the

Government of India.

❖ To develop the treasury bill market and provide investors with financial
instruments of varying short term maturities and to facilitate the cash
management requirements of various segments of the economy, in April
1997 treasury bills of varied maturities were introduced. Generally treasury
bills are of 91 days.

❖ However, 14 day, 28 day, 182 and 364 days treasury bills are also available.
 Treasury Bills (T – Bills)

❖ Since the interest rates offered on treasury bills are very low,
individuals very rarely invest in them.

❖ They are issued at a discount to the face value, and on maturity

the face value is paid to the holder.

❖ The rate of discount and the corresponding issue price are

determined at each auction.
 Certificate of Deposits

❖ Certificates of Deposit (CDs) is a negotiable money market

instrument and issued in dematerialized form or as a Usance
Promissory Note, for funds deposited at a bank or other eligible
financial institution for a specified time period.

❖ Guidelines for issue of CDs are presently governed by various

directives issued by the Reserve Bank of India, as amended from
time to time.
 Certificate of Deposits

❖ CDs can be issued by (i) scheduled commercial banks excluding

Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii)
select all-India Financial Institutions that have been permitted by RBI
to raise short-term resources within the umbrella limit fixed by RBI.

❖ Banks have the freedom to issue CDs depending on their

requirements. An FI may issue CDs within the overall umbrella limit
fixed by RBI, i.e., issue of CD together with other instruments viz.,
term money, term deposits, commercial papers and intercorporate
deposits should not exceed 100 per cent of its net owned funds, as
per the latest audited balance sheet.
 Commercial Paper

❖ CP is a note in evidence of the debt obligation of the issuer. On

issuing commercial paper the debt obligation is transformed into an
instrument. CP is thus an unsecured promissory note privately
placed with investors at a discount rate to face value determined by
market forces. CP is freely negotiable by endorsement and delivery.

❖ These are short term securities with maturity of 7 to 365 days. CPs
are issued by corporate entities at a discount to face value. They
are unsecured promissory notes issued by the companies directly or
through banks / merchant banks.
 Commercial Paper

❖ A company shall be eligible to issue CP provided - (a) the tangible net

worth of the company, as per the latest audited balance sheet, is not
less than Rs. 4 crore; (b) the working capital (fund-based) limit of the
company from the banking system is not less than Rs.4 crore and (c)
the borrowal account of the company is classified as a Standard
Asset by the financing bank/s.

❖ The minimum maturity period of CP is 7 days. The minimum credit

rating shall be P-2 of CRISIL or such equivalent rating by other
agencies.
 Ready Forward (RPs or repos)
❖ In the ready forward deal, a commercial bank or some other
organization may enter into an arrangement with a company,
intending to park its surplus funds for a short period, under which the
bank may sell some securities to the company and repurchase the
same securities at prices (i.e., both buying and selling prices)
determined as mutually agreed.

❖ Hence it is termed as ‘ready forward’.

❖ Ready forwards, are however, permitted only in a limited number of

specified securities.
 Ready Forward (RPs or repos)
❖ Ready forward does not provide any income to the company in the
form of interest, but the company’s income is the difference between
the buying and selling prices.

❖ The income earned on the ready forward is taxable as usual.

❖ The rate of return on a ready forward deal is closely related to the

market conditions prevailing in the money market, which is generally
tight during the busy season, also at the time of the annual closing.
 Banker’s Acceptance
❖ Banker’s acceptances are time drafts drawn on a bank by a firm (the
drawer or exporter) - in order to obtain payment for goods that he /
she has shipped to a customer which maintains an account with that
specific bank.

❖ In other words, it is a short-term promissory trade note for which a

bank (by having ‘accepted’ them) promises to pay the holder the face
amount at maturity.

❖ The draft guarantees payment by the accepting bank at a specific

point of time. Hence, the acceptance becomes a marketable security.
 Banker’s Acceptance
❖ They serve a wide range of maturities and are sold on a discount
basis, payable to the bearer.

❖ Due to their greater financial risk and lesser liquidity, acceptances

provide investors a yield advantage over treasury bills of same
maturity.

❖ However, acceptances of major banks are relatively safe investment.

 Inter Corporate Deposits (ICDs)
❖ This is a popular short-term investment avenue for companies in
India.

❖ As the name itself suggests, an inter-corporate deposit is that deposit

made by one corporate body (company) with another corporate
company.

❖ The deposits are usually made for a maximum of six months.

 Inter Corporate Deposits (ICDs)
❖ There are three types of inter-corporate deposits:
❑ Call Deposits: These types of deposits are expected to be paid on call,
which is whenever its repayment is demanded. Generally, these deposits
are called back giving a day’s notice. But in actual practice the lender has
to wait for at least three days.
❑ Three-month Deposits: These are more popular among the corporate
bodies for parking the surplus funds correspondingly for tiding over the
short-term financial crunch faced by some others.
❑ Six-month Deposits: Generally, inter-corporate deposits do not extend
beyond six months period. This type of deposits is usually made with ‘A’
category companies only.
 Inter Corporate Deposits (ICDs)
❖ Inter-corporate deposits are in the nature of unsecured deposits.
Hence, due care has to be taken to asses and ascertain the credit
worthiness and willingness of the company concerned, with whom it
is intended to be made.

❖ In addition, it must make sure that it adheres to the following

requirements, as stipulated by sections 370 and 372 of the
Company’s Act, 1956 which states a company cannot lend more than
10 per cent of its net worth without prior approval of the central
government and special resolution permitting such excess lending.
 Bills Discounting
❖ Generally bill arises out of trade transaction. Bill is drawn by the
seller (drawer) on the buyer (drawee) for the value of goods
delivered to him.

❖ During the pendency of the bill, if the seller needs finds he/she may
get it discounted.

❖ On the maturity, the bill is presented to the drawee for payment.

 Bills Discounting
❖ A bill of exchange is a self-liquidating instrument.

❖ While participating in bill discounting, a company should ensure that

the bill is backed by letters of credit rather than open bills as the
former are more secure.
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