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Cash management

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Introduction
Cash management is one of the key areas of working

capital management. Apart from the fact that it is the most liquid current asset, cash is the common denominator to which all current assets can be reduced because the other major liquid asset, that is, receivables and inventory get eventually converted into cash. This underlines the significance of cash management. Cash is the ready currency to which all liquid assets can be reduced. Near cash implies marketable securities viewed the way as cash because of their high liquidity.

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Transaction motive
An important reason for maintaining cash balances is

the transaction motive. This refers to holding of cash to meet routine cash requirements 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, financial charges 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 would not need cash for transaction purposes.

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Precautionary motives
In addition to the non-synchronization of anticipated

cash inflows and outflows in the ordinary course of business, a firm may have to pay cash for purpose which cannot be 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 a cushion 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 by buying 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
Yet another motive to hold cash balances is to

compensate banks for providing certain services and loans. Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds, and so on. While for some of these services bank charges a commission or fees, for other they seek indirect compensation. Usually clients are required to maintain a minimum balance of cash at the bank. Since this balance cannot be utilized by the firms for transaction purposes, the banks themselves can use the amount to earn a return. Such balances are bhushan compensating balances

Contd
The compensating cash balances can take either

of 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 cash

balances the two most important are the transaction 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 needs


Synchronization of cash flows Short costs (i) transaction costs (ii) borrowing costs (iii) loss of cash-discount

(iv) cost associated with deterioration of the credit


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rating (v) penalty rates Excess cash balance cost Procurement and management Uncertainty and cash management

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Baumol model
The Baumol model of cash management provides a

formal approach for determining a firms optimum cash balance under certainty. It considers cash management similar to an inventory management problem. The purpose of this model is to determine the minimum cost amount of cash that a financial manager can obtain by converting securities to cash, considering the cost of conversion and counterbalancing cost of keeping idle cash balances which otherwise could have been invested in marketable securities
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Contd
The total cost associated with cash management,

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

Contd
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. 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 C

C/2

Average

0
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T1

T2

T3

Time

Contd
The firm incurs a holding cost for keeping the

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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 holding cost 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 bhushan balance of the period (zero) divided by 2

Contd
The firm incurs a transaction cost whenever it

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converts its marketable securities to cash. Total number of transactions during the year will be total funds requirements, 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 b then total transaction cost will be: transaction cost or total conversion cost per period = b(T/C) Where b= cost per conversion T= total transaction cash needs for the period bhushan C= value of marketable securities sold at each

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 the total cost is minimum
C= 2bt

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Contd
Annual cost Slope = 0 iC Minimum total cost Opportunity Cost =

Total Cost

Tb Transaction Cost =

Cash Balance
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Miller-Orr model
The limitation of boumol model is that it dose not

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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 cash flow variation . Miller Orr assumes that the changes in cash balance over a given period are random in size The miller Orr model provides for two control limits the upper control limit and lower control limit bhushan as well as return point

The Miller - Orr Model


Upper Limit Buy Securities

UL

Z or Return point

Lower Limit

Sell Securities
Time

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 the cash level back to the normal level.

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Contd
While the value of lower control limit (LL) is set by

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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 4I UL = 3RP-2LL

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Control of cash collection and disbursement.


The strategic aspect of efficient cash

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management approach are: speedy collection of accounts receivables and 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 are two broad approaches to do this. In the first place the customer should be encouraged to pay as quickly as possible. Secondly, the payment from customer should be converted into cash without bhushan any delay.

Prompt payment by customer


One way to ensure prompt payment by customer

is prompt 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 will speed up payment by customers. Another, and more important, technique to encourage prompt payment by customers, is the practice of cash discounts.
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Early conversion of payments into cash.


Once the customer makes the payment by writing a cheque

in the favor of the firm, the collection can be expedited by prompt encashment of the cheque. There is a lag between the time a cheque is prepared and mailed by the customer and the time 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 post offices to transfer the cheque from the customer to the firm referred 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 the customer 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 cheque written 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 policy of 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

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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 firm under this system the firm will have a large number of bank accounts operated in the areas where the firm has its branches. All branches may not have the collection centers. The selection of the collection center will depend bhushan upon the volume of billing.

Contd
The collection centers will be required to collect

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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 firm has a major account usually disbursement account. Funds can be transferred to a central or concentration bank by telex or fax or electronic mail. Decentralized collection system saves mailing bhushan and processing time and thus reduces the deposit

Lock-box system
Lock-box system another technique of speeding

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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 a number of collection centers, considering customer location and volume of remittance. bhushan

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 pickup 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 firm the bank prepares detailed records of the cheques picked up.
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Contd
Two main advantages are

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 the system should be used or no depends upon the comparison between its cost and benefits.
1.
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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 simply allows

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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 financial manager makes investments in some what ad hoc (unplanned, unprepared) manner such a strategy makes some contribution, though not the optimal contribution, to profitability without impairing the liquidity of the firm. It is followed by the firms which cannot devote enough time and bhushan resources to management of securities.

Contd
Ride the yield curve: this is a strategy to

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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 they appreciate more, compared to short term securities. On the other hand, if the financial manager believes that the interest rate will rise in the near future, he would sell longer term securities. This strategy hinges (centered) on the assumption that the financial manager has bhushan superior interest rate forecasting ability.

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) minimize transaction cost

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Contd
Utilize control limits: there are some models of

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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 balance hits the lower limit then a certain amount of marketable securities should be liquidated. bhushan

Contd
Manage with a portfolio perspective: according to

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the portfolio theory there are two key steps in portfolio selection. Define the efficient frontier: the efficient frontier represents 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 and a 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 bhushan utility.

Stone model
The Stone Model is somewhat similar to the Miller-Orr Model 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 of cash may naturally correct itself. If the upper control limit is reached, but is to be followed by cash outflow days that would bring the cash balance down to an acceptable level, then nothing is done. If instead the surplus cash would substantially remain that way, then cash is withdrawn to get the bhushan cash balance to a predetermined return point.

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Contd
Of course, if cash were in short supply and the lower

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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, bhushan concentration, and disbursement to other methods.

Long term cash forecasting


Long term cash forecast are prepared to give an

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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 firms financial condition for a long period. Long term cash forecast reflects the impact of bhushan growth, expansion or acquisition; it also indicates

Contd
The major uses of long term cash forecast are:

It indicates as companys future financial needs,

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. It helps to improve corporate planning. Long term cash forecasts compel each division to plan for future and to formulate projects carefully.
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Short term cash forecast


It is comparatively easy to make short term

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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 debts. Planning forward purchase of inventories Taking advantages of cash discounts Guiding credit policies bhushan

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

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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. In other words the net cash position (surplus/ deficiency) of a firm as it moves from one budgeting sub period to another is highlighted by the cash budget. bhushan

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