Cash Management

 

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CHAPTER II

MANAGEMENT OF CASH POSITION

                                            Cash is a strange current asset essential for the successful operation in the product cycle. Cash is the basic input needed to keep the business running on a continuous basis, it is also the ultimate output expected to the realized by selling the service or product manufactured by the firm. Cash is considered as to be the most significant and the least productive asset that a firm holds. Cash constitutes only a small portion of the total current asset ie; 1% to 3%. Yet managers’ considerable time is devoted in managing it. Cash is the money, which a firm can disperse immediately without any restrictions. It includes coins, currencies, cheques etc.

           

Cash management is concerned with the managing of: -

• Cash in flows and out flows of the firm.
• Cash flows within the firm.
• Cash balances held by the firm at point of time by financing deficit or investing the surplus.

The management of cash is important because it is difficult to predict cash flows accurately, particularly the inflows and there is no perfect coincidence between the inflows and outflows of cash. In order to resolve the uncertainty about cash flow prediction and lack of synchronization between cash receipts and payments, the firm should develop appropriate strategies for cash management.

      MOTIVES FOR HOLDING CASH

1. Transaction Motive: -

It requires a firm to hold cash to conduct in business in ordinary course. The firm needs cash primarily to make payments for purchases, wages, salaries, other operating expenses, taxes, dividends etc. The transaction motive mainly refers to holding cash to meet anticipated payments, whose timing is not perfectly matched without cash receipts.

2. Precautionary Motive: -

The precautionary motive is the need to hold cash to meet contingencies in the future. It provides a cushion or buffer withstand some unexpected emergencies. It stronger the ability of the firm to borrow at short notices then the need for precautionary balance will be less. The amount of cash set-aside for precautionary reasons will be invested in high liquid and low risk marketable securities.

3. Speculative Motive: -

It relates to the holding of cash for investing in profit making opportunities as and when they arise. The opportunity to make profit may arise when the security prices change. The firm will hold cash when it is expected that there will be a rise in price of commodities and securities. The firm will also purchase securities when it is expected that interest rates will rise and security prices will fall. Then the firm will be benefited by the subsequent rise in prices of securities.

4. Compensating Motive: -

             Business of today is predominantly depend on the commercial bank for financial support for some of services; the bank charges a commission or service charges but for some others it insist that a pre-determined minimum balance be kept with the bank, which should not be withdrawn in the ordinary course of business, for instance, if a bank guarantee is issued by the bank, guarantee charges based on the period and amount are debited by the bank. In addition it may ask for relation of some minimum balance too. Such balance is known as Compensating balance.

5. Expansion Motive: -

            It refers to the motive of accumulating cash to meet the requirements of expansion envisaged by the business. Holding of cash for such purposes been described as business expansion motive.

Factors determining the quantum of cash balance to be held in hand

1. Maturity structure of the firm’s liabilities
2. Firm’s ability to borrow at short notice
3. Philosophy of management regarding liquidity and risk of insolvency
4. Efficient planning and control of cash
5. Degree of deviation between the expected and actual net cash flows

CASH MANAGEMENT

       There are four phases of Cash Management. They are:

1. Cash planning and preparation of cash budget
2. Managing the cash flows
3. Optimum cash level
4. Investing surplus cash

      CASH PLANNING

            Cash planning is a technique to plan and control the use of cash. It protects the financial condition of the firm by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given period.

CASH FORECASTING AND BUDGETING

            Cash budget is the most significant to plan for and to control cash receipts and payments. A cash budget is a summary statement of the firms expected cash inflows and outflows over a projected time period. It gives information on the timing and magnitude of expected cash flows and cash balances over the projected period. Cash forecasting may be done on short or long term basis. Generally forecast covering period of one year or less are considered short terms. Those extending beyond one year are considered long term.

SHORT TERM FORECASTING

            It is comparatively easy to make short term forecast. The important functions of carefully developed short term cash forecast are;

1. To determine operating cash requirement
2. To anticipate short term financing
3. To manage the investment of surplus cash
4. Checking accuracy of long range forecasting
5. Scheduling payments in connection with capital expenditure programmes
6. Guiding credit policies

                 Two most commonly used methods of short term cash forecasting are;

1 The Receipts and Disbursement Method

      2The Adjusted Net Income Method

1. The Receipts and Disbursement Method

            Cash flows in and out in most companies are on a continuous basis. The prime aim of receipts and disbursement forecast is to summarize these flows during a pre-determined period. In case of those companies where each item of income and expense involves flow of cash, this method is favored to keep a close control over cash

.

2. The Adjusted Net Income Method

            This method of cash forecasting involves the trading of working capital flows. It is some times called Sources and Uses approach objectives of adjusted approach are;

• To project the companies need for cash at a future date and;
• To show whether the company can generate the required funds internally and it not how much will have to be borrowed or raised from the capital market.

LONG TERM CASH FORECASTING

            Long-term cash forecast are prepared to give an idea of companies’ financial requirements in the distant future. They are not as detailed as the short term forecast. Long term cash forecasting reflects the impact of growth expansion or acquisition, it also indicates financing problems arising from these developments. The major uses of the long term cash forecast are;

1)      It indicates company’s future financial needs, especially for its working capital          requirements.

2)      It helps to evaluate proposed capital projects, it pin points the cash required, to finance these projects as well as the cash to be generated by the company to support them.

3)      To help to improve corporate planning long term cash forecast compel each division to plan for future and formulate projects carefully.

MANAGING THE CASH FLOWS

            Once the cash budgets have been prepared and appropriate net cash flow established, the financial manager should ensure that there does not exist a significant deviation between projected cash flows and actual cash flows. To achieve this cash management efficiency will have to be improved through a proper control of cash collection and disbursement. The twin objectives of managing the cash flows should be to accelerate cash collections as much as possible and to decelerate or delay cash disbursements as such as possible.

1.      ACCELERATING CASH COLLECTION

A firm can conserve cash and reduce its requirements for cash balances if it can be speed up its cash collections. Reducing the lag can accelerate cash collections or gap between the times a consumer pays bill and the time cheque is collected and funds become available for the firms use. A number of methods may be employed to speed up the cash inflows and maximize available cash. They are: -

                                i.            Concentration Banking or Decentralized Collection

To accelerate the cash turnover a nation wide organization may instead of a single collection centre establish collection centers in various marketing centers of the country. The customers are instructed to remit their payments to the collection centre of their region. Collection centers will deposit this money in their local bank account. Collection center will transfer funds above some pre-determined minimum to a central or concentration bank account generally at the firm’s head office. Concentration banking helps to save mailing and processing time

                              ii.            Lock Box System

This method will help to reduce the time interval from the mailing of the cheque to the use of funds by the company. Under this arrangement the company rents lock box from post office. The customers are instructed to mail cheques to the lock box. The companies bank branch picks up the mail from the lock box several times a day and deposits them in the company’s account and on the same day sends the company by air mail the deposit slip listing all the cheques deposited.

                            iii.            Quick Deposit of Customers Cheque

The amount of cheque sends by customers, which are not yet collected, is called collection or deposit float. This can be avoided by making an arrangement for quick deposit of the cheques in the bank in the moment they are received.

                            iv.            Letter of Credit

A letter of credit is an undertaking by a bank to honor the obligation of a customer up to a specified amount if the customer fails to do so. The basic advantage is that of guaranteed payment in case the order is executed as per the terms. As an additional advantage it act as a cash management tool also, the business can get instantaneous payment of full amount or as agreed with the customer through the bank, against delivery of dispatch documents. It need not wait till goods reach the customer. Sometimes even before the dispatch of goods the bank provides advance against the letter of credit.

                              v.            Pre Authorized Debits (PAD)

Pre authorized debits is one of the latest technique for the acceleration of cash inflow. Under this system on a pre determined date the bank of Business Company automatically debits the bank of the customer with the due amount. The bank has already been authorized by the customer to honor such debit. There is no movement of any document script or cheque; merely a computer entry is needed for this. This results in the reduction of cost of printing of demand deposit note, then bankers charges etc.

                            vi.            Post Dated Cheques

This is indigenous version of Pre Authorized Debits. If the payments to be released have a definite amount and definite periodicity, the payer sends post-dated cheques to the payee. The relevant cheques are deposited at the scheduled time. It has the benefit of reducing postal float tremendously since this float is involved only once.

2.      DELAYING PAYMENTS

A company can keep cash by effectively controlling disbursements. Following methods can be used to delay disbursements: -

                                i.            Centralization of payments

The payments are centralized and payments should be made through drafts or cheques. When cheques are issued from the main office then it will take time for the cheques to be cleared through the post. The benefit of cheque collecting time is awaited.

                              ii.            Making use of float

Here float is the difference between the balance shown in the company’s cashbook (Bank Column) and balance in passbook of the bank. Whenever a cheque is issued the balance at bank in cashbook is reduced. The party to whom the cheque is issued is may not present it for payment immediately. If the party is at some other station, then the cheque will come through post and it may take a number of days before it is presented until the time, the cheques are not presented to bank for payment there will be a balance in the bank. The companies make use of this float, if it is able to estimate it correctly.

                            iii.            Paying on last date

The disbursement can delayed on making payment on the last due date only. It can help in using the money for short periods and firm can make use of cash discount also.

                            iv.            Adjusting payroll funds

This can also help a company to economize cash. If the company is currently disbursing pay to its employees weekly, it can effect substantial cash savings, if pay is disbursed only once in a month.

            Other Methods

                        Cash balance like idle in the company’s name in several banks could be minimized without any loss in banking services. The important measures for this purpose are;

    1. To eliminate may such bank account as where originally opened and subsequently maintained just for building up strong image in the market. By closing these accounts the company can release funds for investment in profitable channel.

    2. Another device of improving the efficiency of cash utilization in the company is to set a maximum limit, which each bank of the company will maintain at one time. The banks may be given instruction that any balance is excess of the stipulated limit should be immediately transferred to the company’s principal book. The principal bank in turn may be instructed to invest funds in excess of the limit in highly liquid risk less securities.

DETERMINING THE OPTIMUM CASH BALANCE

A firm maintains the operating cash balance for transaction purposes. It my also carry additional cash as a buffer or safety stock. The amount of cash balance will depend on the risk return trade off. The firm should maintain optimum cash balance i.e., just enough neither too much nor too little.

OPTIMUM CASH BALANCE UNDER CERTAINITY – BAUMOL’S MODEL

                        The Baumol’s cash management model provides a formal approach for determining a firm’s optimum cash balance under certainity. It considers cash management similar to an inventory management as much the firm attempts to minimize the sum of the cost of holding cash and the cost of converting marketable securities to cash.

                        The Baumol’s model makes the following assumptions;

1)      The firm is able to forecast its cash needs with certainity.

2)      The firm’s cash payments occur uniformly over a period of time.

3)      The opportunity cost of holding cash is known and it does not change over time.

4)      The firm will incur the same transaction cost whenever it converts securities to cash.

O       T1             T2                 T3

            Let us assume that the firm sells securities and starts with a cash balance of C rupees. As the firm spends cash its cash balance decreases steadily and reaches to Zero. The firm replenishes its cash balance to C rupees by selling marketable securities. These patterns continue over time. Since the cash balance decreases steadily, the average cash balance will be C/2

                        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 K, then the firm’s holding cost for maintaining an average cash balance is;

                                    Holding cost = K (C/2)

                        The firm incurs a transaction cost whenever it converts its marketable securities to cash. The total number of transactions during the year will be total funds requirements i.e; 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 F then the total transaction cost will be;

                        Transaction Cost = F (T/C)

The total annual cost of the demand for cash will be;

                        Total Cost = K (C/2) + F (T/C)

The holding cost increases as demand for cash C increases and the transaction cost reduces because with increasing C. the number of transaction will decline. Thus there is a trade off between the holding cost and the transaction cost.

                        Optimum Cash Balance (C) = √2FT / K

            Where: C = Optimum cash balance

                         F = Fixed cost per transaction

                         T = Total requirement of cash during the year

                         K = Opportunity cost of holding cash

                                    The optimum cash balance will increase with increase in per transaction cost and total funds required and decrease with opportunity cost.

O                               C            Cash

Cost Trade off – Baumols Model

OPTIMUM CASH BALANCE UNDER UNCERTANITY THE MILLER – ORR MODEL

                 The limitations of the Baumols model are that it does not allow the cash flows to fluctuate. Firms in practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and out flows. The M.O Model overcomes this shortcoming and allows for daily cash flow variations.

            The M.O Model provides for two control limits. The upper control limit and lower control limit as well as a return point. If the firm’s cash flows fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities to come back to a normal level of cash balance (the return point). Similarly when the firm’s cash flows wander and hit the lower limit, it sells sufficient marketable securities to bring the cash balance back to the normal level. (The return point)

            The M.O Model is more realistic since it allows variations in cash balance within lower and upper limit. The distance between upper control limit and lower control limit is called Z

            Z = Upper Limit – Lower Limit

              i.e; Z = (3/4 x Cσ² / i) ¹/³

                        Where C = Transaction Cost

                                    i = Interest Rate

                                    σ = Standard Deviation of Net Cash Flows.

 ORGLER’S MODEL

            According to Orgler’s Model an optimal cash management strategy can be determined through the use of multiple linear programming model formulation of the model requires that the financial managers must specify an objective function and then specify a set of constraints.

INVESTING SURPLUS CASH OR ALLOCATION OF FUNDS BETWEEN CASH           AND NEAR CASH ASSETS

                 There is a close relationship between cash and money market searching or other short-term investment alternative. Excess cash should normally been invested in those alternative which can be conveniently and promptly converted in to cash.

            A firm can invest its excess cash in many types of marketable securities. The primary criterion in selecting a security or investment opportunity will be it quickest convertability in to cash when the need for cash arises. In choosing among alternative investment a firm should examine for basic features of security that are;

1. Safety
2. Marketability
3. Maturity
4. Taxability

TYPES OF SHORT TERM INVESTMENT OPPORTUNITIES

1. Treasury Bills
2. Commercial Papers
3. Certificate of Deposits
4. Inter Corporate Deposits
5. Money Market Mutual Fund

EVALUATION OF CASH MANAGEMENT

                      Responsibility of finance manager is not over with allocation of funds between cash and near cash assets. He has to evaluate the progress of work in respect of utilization of funds in cash. So as to ascertain whether funds are utilized in confirm with plans and policies laid down in respect there fore. Evaluation process involves comparison actual performance against pre determined plans and objectives finding out discrepancy if any, analyzing these variations in order to pinpoint the under lying causes and finally taking remedial steps to correct the unfavorable deviation, so that the performance confirms to the plans and goals of the company.

GOALS OF CASH MANGEMENT

1. To satisfy day to day requirements of cash
2. To provide for scheduled major payments
3. To face un expected cash payment
4. To build image of credit worthiness
5. To minimize the operating cost of cash mgt
6. To seize potential opportunities for profitable investment

FUNCTIONS OF FINANCE MANAGER

1. To forecast cash inflows and out flows
2. To plan cash requirement
3. To determine the safety levels for cash
4. To regulate control cash inflows and outflows
5. To determine the criterion for investment of excess cash
6. To avail banking facilities and maintain good relations with bankers

FLOAT

              A business at times deals with two balances associated with its banks account:

The balance operating in its own Books of accounts and the other the actual cash balance as displayed in books of the bank. The reason for the difference in these two balances can be many. The two most prominent reasons are;

1.      Cheques presented by the business but not yet collect

2.      Cheques issued by the business but not yet presented by the business

3.       

                The sum total of these two is known as float. The former is known as collection float, and the later as disbursement float.

COLLECTION FLOAT

                       The collection float is represented by the aggregate of the amounts of the cheques, which have been deposited in the bank, but are in the process of collection by the bank. As soon as the cheques are deposited in the bank, the amounts are debited to the bank account appearing in the books of the business. But the bank will credit its customer’s account only when the actual amount is realized or collected. The time lag in the two results in the difference of balances known as “Collection Float.”

            As a matter of fact collection float is a part of overall deposit float, which additionally covers mailing float and processing float. Mailing Float arises due to the time lag involved in the issue of cheques by customers and their receipts by the recipients. Processing float arises on account of time taken by the business for processing the cheques for presentation to the bank.

  DISBURSEMENT FLOAT

            Disbursement float is sum total of all the cheques which have been issue to the suppliers but are in the process of being presented to the bank for payment. The bank account in the books of the business is credited as soon as cheques are drawn on it and send to suppliers, but the bank would debit the account of its customer only on the receipt of the cheques from the banker of suppliers. The difference between the two balances is known as Disbursement Float.

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