Treasury Management and Control

Prof. Prapti Paul

Introduction
Cash management refers to the management of cash and bank balance 1.

2. 3. 4.

or in a broader sense its the management of cash inflows and outflows. Every firm must have a minimum cash balance. There are different motives for holding cash: Transaction motive: demand for cash flow arising out of day to day transactions. In order to meet the obligations for cash flows arising in the normal course of business, every firm has to maintain adequate cash balance. Precautionary motive: is based on the need to maintain sufficient cash to act as a cushion or buffer against unexpected events. Speculative motive: cash maybe held for speculative purposes in order to take advantage of potential profit making situations. Compensation motive: commercial banks require that in every current account there shd always be a minimum cash balance. This amount remains as a permanent balance with the bank so long as the current account is operative.

 Objectives of cash management: Built ard 2 goals: 1) to provide cash needed to

meet the obligations, and 2) to minimize the idle cash held by the firm.
Cash management: Planning Aspects: the implementation of an efficient

cash management system starts with the preparation of a plan of firms operations for a period in future. This plan will help in preparation of a statement of receipts and disbursements expected at different point in time of that period. It will enable the management to pinpoint the exact timing of excess cash or shortage of cash etc..In order to take care of all these transactions, the firm shd prepare a cash budget.
A cash budget is a summary of movement of cash during a particular period.

There are 3 methods of preparing cash budgets: (i) adjusted Net Income, (ii) Proforma balance sheet, and (iii) cash receipts and disbursements. In all the methods the information with which the final cash budget is constructed is basically the same.

 Illustration 1: the foll forecasts have been made for ABC Ltd. for the period

Jan-Apr 2007
Jan sales Raw material Manuf. Exp Loan install Rs.75,000 70,000 10,000 1,000 Feb Rs.1,05,000 1,00,000 20,000 11,000 Mar Rs.1,80,000 80,000 29,000 21,000 Apr Rs.1,05,000 85,000 16,000 21,000

Additional info: (i) all sales are made on credit basis. 2/3 of debtors are

collected in the same month and balance next month. There is no expected bad debt. The debtors on Jan 1st, 2007 were Rs.30,000. (ii) the minimum cash balance, the firm must have is estimated to be Rs.5,000, however, the cash balance on Jan 1st, was Rs.6,500. (iii) borrowing, if any can be made in multiples of Rs.100 only. Prepare cash budget for the period of 4 months( ignore interest on borrowings).

 Solution 1:

cash budget for the period Jan-Apr 2007 Jan Feb 5,500 25,000 70,000 1,00,500 Mar 5,000 35,000 1,20,000 1,60,000 Apr 5,000 60,000 70,000 1,35,000

Opg. Cash Inflows: Drs (prev.month) Drs(cur. month) Total cash avail (A) Outflows: Raw material Manuf. Exp Loan install Total outflows (B) Cash Bal (A-B)

Rs.6,500 30,000 50,000 86,500

70,000 10,000 1,000

81,000 5,500

1,00,000 20,000 11,000

1,31,000 -30,500 35,500

80,000 29,000 21,000

1,30,000 30,000 (25,000)

85,000 16,000 21,000

1,22,000 13,000 (8,000)

Borrowings (refund) -

 Cash Management: Control Aspects- after the preparation of cash

budgets, the financial manager should ensure that there are no significant differences between the expected/ budgeted cash flows and the actual cash flows. This requires controlling and reviewing of the whole exercise on a regular basis.
The efficiency of the firms cash management program can be enhanced by the

knowledge and use of various procedures aimed at: (a) accelerating cash inflows, and (b) controlling cash outflows.
Controlling inflows: the fin. manager shd take steps for speedy recovery

from the debtors and for this purpose proper internal control system should be installed by the firm. Once the credit sales have been effected, there shd be a built in mechanism for timely recovery from the debtors. Periodic statements shd be prepared to show the outstanding bills. Incentives offered to the customers for early/ prompt payments shd be well communicated to them. Once the cheques/ drafts are received frm customers, no delay shd be there in depositing these receipts with the banks. The time lag in collection of receivables can be considerably reduced by managing the time taken by postal intermediaries and banks. Concentration banking and lock box system help reduce this time lag.

 A firm may open collection centres (banks) in different parts of the country to

save the postal delays. This is known as concentration banking. Under this system, the collection centres are opened as near to the debtors as possible, hence reducing the time in dispatch, collection etc.. The firm may instruct the customers to mail their payments to a regional collection centre/ bank rather than to the central office. This results in saving of time and hence better cash management. However concentration banking involves a cost in terms of minimum cash balance required with a bank in form of normal minimum cost of maintaining a current account. So concentration banking as a tool of controlling inflows may be availed by big firms only.
Under the lock box system, the customers mail their payments to a post office

near their workplace. The firm arranges with a local bank or some other agency to collect the payments and credit to the firms account as quickly as possible. The lock box system is economical only if there is a relatively large no. of payments being received in a particular area, as the expenses attached for maintaining the system may be significant.

 Controlling outflows: an effective control over cash outflows or payments

also help a firm in better cash management and reducing cash requirements. A financial manager shd try to slow down the payments as much as possible. However care must be taken that goodwill and credit rating of the firm is not affected.
Playing the float: when a firm receives or makes payments in the form of

cheques etc., there is usually a time gap between the time the cheque is written and when it is cleared. This time gap is known as float. The float for the paying firm refers to the time that elapses between the point when it issues a cheque and the time at which the funds underlying the cheque are actually debited to the bank account. For the payee firm, float refers to the time between the receipt of the cheque and the availability of the funds in its account. So float refers to the funds that have been dispatched by a payer (the firm making the payment) but are not in a form that can be spent by the payee (the firm receiving the payment).
Float has 3 components: 1) Mail time: it is the time between the issue of

cheque and its receipt by the payee. 2) processing time: time between the cheque is received by the payee and the deposit of the cheque in the bank account of the payee, and 3) collection time: amount of time for transferring funds, through banking system, from the payers account to that of the payee.

 When a cheque is issued by the paying firm, the bank balance of the firm is not

immediately reduced, rather the bank reduces the balance only when the cheque is presented to it either personally or through the clearing system. The amount of cheques issued but not presented for payment is known as the payment float.
When the firm receives a cheque from the customer and deposits the cheque in

the firms account the amount is not immediately credited to the firms account, rather the banks credit the cheque only when it is cleared by the paying bank. The amount of cheques deposited into the banks, but not yet cleared, is known as receipt float. The difference between the payment float and receipt float is known as net float.
Illustration 2: Tiffin services Ltd. issues cheques of Rs.3,000 per day and

receives cheques of Rs.2,000 per day. The payment float is 7 days while receipt float is 2 days on an avg. find out different floats for the firm.
Solution 2: different floats for the firm:

disbursement =3,000*7=Rs.21,000
collection= 2,000*2= Rs.4,000 net floats=21,000-4,000 = Rs.17,000 So the firms net book balance is Rs.17,000 less than the actual balance available in the bank.

 Optimum Cash Balance: Few Models- the problem of determining optimum

cash balance for a firm implies a trade-off between risk and return of maintaining cash balance.
Baumols Model: this model is the same as EOQ model of inventory mgmt.

This model attempts to balance the income foregone on the cash held by the firm against the transaction cost of converting cash into marketable securities or viceversa.
Assumption: the Baumols model assumes that the firm uses cash at an already

known rate per period and that this rate of use is constant.
Holding cost: there is always a cost of holding cash by the firm. This cost maybe

opportunity cost in terms of interest foregone on the investment of this cash.

Transaction cost: whenever cash is to be converted into marketable securities, or

vice-versa, there is always a cost involved in the form of brokerage, commission etc..
This model is based on the proposition that in order to reduce the holding cost, a

firm keeps the least amount of cash in hand. However as the level of cash depletes, the firm can acquire cash by selling some of its marketable securities. Each time the firm transacts in this way, it bears transaction cost, so it will like to transact as occasionally as possible. This could be done by maintaining a higher cash level involving a high holding cost. Thus a firm has to deal with the holding cost as well as transaction cost.

 The optimum cash balance is found by controlling the holding cost as well as

transaction cost so as to minimize the total cost of holding cash.

Model can be presented as follows:

C= (2FT)/r where C = cash required each time to restore balance to minimum cash F= total cash required during the year. T= cost of each transaction between cash and marketable securities r= rate of interest on marketable securities. As per Baumols model, the firm should start each period with the cash balance equaling C and spend gradually until its balance comes to zero. At this time, the firm shd replenish the cash equaling C from the sale of marketable securities.
Limitations: 1.

The model assumes a constant rate of use of cash. Generally the cash outflows in any firm are not regular and hence this model may not give correct results. of investment as well as the maturity period.

2. The transaction cost will be difficult to measure since this depends upon the type

 Miller-Orr model: they have expanded Baumol s model which is not

applicable if the demand for cash is not steady. They argue that changes in cash balance over a given period are random in size as in direction. The cash balance of a firm may fluctuate irregularly over a period of time. The model assumes (i) out of the 2 assets i.e. cash and marketable securities the latter has a marginal yield, and (ii) transfer of cash to marketable securities and vice- versa is possible without any delay but at a cost.

 The model has specified two control limits for cash balance. An upper limit, H,

beyond which cash balance need not be allowed to go and a lower limit, L, below which the cash level is not allowed to reduce. The cash balance shd be allowed to move within these limits. If the cash level reaches the upper control limit, H, then at this point a part of the cash shd be invested in marketable securities in such a way that the cash balance comes down to a pre-determined level called the return level , R. If the cash balance reduces below the lower level, L, then sufficient marketable securities shd be sold to realize cash so that the cash balance is restored to the return level, R. No transaction between cash and marketable securities is undertaken so long as the cash balance is between the 2 limits of H and L.

 Illustration 3: prepare a cash budget of XYZ Ltd., on the basis of the foll info for

the six months commencing April, 2007

1) Cost and prices remain unchanged and firm maintains a minimum cash

balance of Rs.4,00,000 for which bank overdraft may be availed if required.

2) Cash sales are 25% of the total sales and the balance 75% will be credit sales.

60% of the credit sales are collected in the month following the sales, balance 30% and 10% in the two months thereafter. No bad debts are anticipated.
3) Sales forecasts are as follows:

2007 Jan Feb Mar Apr May

Amount 12,00,000 13,33,333 16,00,000 6,00,000 8,00,000

2007 Jun Jul Aug Sep Oct

Amount 8,00,000 12,00,000 10,00,000 8,00,000 12,00,000

4) Gross profit margin 20% 5) Quarterly interest payable Rs.30,000; rent payable Rs.8,000 p.m 6) Capital expenditure expected in September is Rs.1,20,000.

7) Anticipated purchases and wages for 2007 are: Purchases April May June July August September Rs. 6,40,000 6,40,000 9,60,000 8,00,000 6,40,000 9,60,000 Wages 1,20,000 1,60,000 2,00,000 2,00,000 1,60,000 1,40,000

 Solution 3:

Cash Budget April to September 2007 Rs. In lacs Apr May Jun Jul Aug Sept

A. Cash inflows: sales realization cash sales credit sales (working note) Total Inflows B. Cash outflows: Materials wages Interest payable Capital expenditure Rent payable Total Outflows Opening balance Closing balance

1.50 11.10 12.60 6.40 1.20 .08 7.68 4.00 8.92 (4.00+ 12.607.68)

2.00 7.30 9.30 6.40 1.60 .08 8.08 8.92 10.14

2.00 6.15 8.15 9.60 2.00 .30 .08 11.98 10.14 6.31

3.00 5.85 8.85 8.00 2.00 .08 10.08 6.31 5.08

2.50 7.80 10.30 6.40 1.60 .08 8.08 5.08 7.30

2.00 7.80 9.80 9.60 1.40 .30 1.20 .08 12.58 7.30 4.52

 Working notes solution 3:

collection from credit sales:

Apr Credit sales 4.50 Credit sales-collections: 60% of preceding month 7.2 30% of next preceding month 3.00 10%of next preceding month 0.90 Total collections 11.10 May 6.00 2.70 3.60 1.00 7.30 Jun 6.00 3.60 1.35 1.20 6.15 Jul 9.00 3.60 1.80 0.45 5.85 Aug 7.5 5.40 1.80 0.60 7.80 Sep 6.00 4.50 2.70 0.60 7.80

 Illustration 4: find out the optimum cash balance as per Baumols Model for the

foll:
Annual cash needed Transaction cost Interest rate Rs.2,40,000 Rs.100 per conversion Rs.12% p.a

What are the opportunity costs of holding cash, the transaction cost and the total cost. What would these be if cash held is Rs.15,000 or Rs.25,000?
Solution 4: optimum cash balance as per Baumols Model is:

C= (2FT)/r

=(2*2,40,000*100)/.12
=Rs.20,000 Avg. cash balance Interest cost@12% No. of transaction(Rs.2,40,000/20,000) Transaction cost(Rs.100*12) Total cost (Rs.1,200+1,200) Rs.10,000 (20,000/2) Rs.1,200 12 Rs.1,200 Rs.2,400

 If cash held is Rs.15,00 or Rs.25,000, different costs would be:

Cash balance Rs.15,000 Cash balance Rs.25,000

Average cash Rs.7,500 Rs.12,500

Interest cost @12%

No of transactions Transaction cost @Rs.100 each Total cost

Rs.900
16 Rs.1,600 Rs.2,500

Rs.1,500
9.6 Rs.960 Rs.2,460

In both cases the total cost is more than the cost as per Baumols Model.