16 Managing Cash

Reasons for Holding Cash

Cash is justifiably considered to be the most unproductive of all assets. In
fact, any asset that is idle, or is held in a quantity greater than necessary, is
unproductive. You will recall that a firm raises capital at a cost, and uses the
funds raised to buy assets. Now if an asset is bought but not used, it incurs
costs without producing returns. The situation is more serious in the case of
cash because idle cash on the one hand attracts costs and on the other loses
value due to inflation. So why do companies hold cash? There are essentially
three reasons, or motives, for holding cash: transactional motive,
precautionary motive and speculative motive.

Transactional Motive
Cash is needed to meet day to day transactions of the company. Paying
routine expenses and meeting regular payment obligations to suppliers and
lenders is necessary to keep the business wheels turning. A certain quantity
of cash must therefore always be available to prevent the business from
coming to a grinding halt.

Precautionary Motive
In addition to routine commitments, a company must also keep some cash for
meeting any unforeseen or unexpected outflows, e.g. an accident in the
factory demanding immediate heavy repairs, a fire in the warehouse that
suspends supplies to customers and therefore dries up incoming cash flow,
an unexpected demand from a lender to pay up before due date, etc. Just as
households maintain a small savings nest to meeting the unforeseen
expenses, so do businesses maintain a decent cash balance for precautionary
reasons.

Speculative Motive
Sometimes, a company comes across an opportunity too good to be missed.
Advantage of such a situation can only be taken if there is sufficient cash
available. For example, if a manufacturer is getting rid of its old stock and is
willing to offer a handsome discount to any one who is willing to buy the
entire stock for cash, or on very short credit terms, a wholesaler may benefit
tremendously if he is able to seize the moment. A degree of liquidity is
needed to benefit from such opportunities.

Cash, Near Cash and Potential Cash

These three terms are frequently used in relation to liquid funds held or
needed by a company. Cash of course includes physical cash comprising of
currency notes and coins held in the office, at the factory or at branches of a
company. In addition, it also includes cash held in savings or current
accounts of a bank from where it can be withdrawn without any notice or
penalty. Near Cash refers to bank balances or marketable securities held by a
company which can be converted into cash at a minimum of notice or loss or
penalty. For example, cash held in a term deposit account can often be
withdrawn by giving a short notice and foregoing some interest income.
Similarly, marketable securities like government bonds or shares of listed
companies can be liquidated almost immediately but at a possible loss.
Potential cash essentially refers to borrowing facilities available to a company
which it has not yet fully utilized. For example, if a company has negotiated a
bank overdraft limit of say Rs. 2,000,000 but it has currently overdrawn only
Rs. 745,000, it has a potential cash balance of Rs. 1,255,000. When
managing cash, a finance manager should look at all forms of cash. For
example, there is little justification in maintaining large cash balances in
current account, or even in near cash form, for speculative reasons. Making
timely arrangements for potential cash can equally serve the speculative
motive for holding cash.

Cash Management Policy

A company must draw up a formal cash management policy. The basic
contents of the policy are:

a. Procedures for opening and operating bank accounts of the company

clearly laying down the scope of authority for all concerned officials in
this regard.
b. Procedures for receipt and banking of funds.
c. Procedures for making payments, and moving funds within different
accounts of the company, clearly defining the authority limits for those
approving the payments
d. Procedure for and authority of officials who can negotiate loans etc. on
behalf of the company.
e. Guidelines for levels of cash to be held in different forms (e.g. cash in
hand, cash at bank in current account, near cash, etc.) at different
times of a financial year.

Main Problem with Cash Management

The main problem experienced in management of cash is the fact that it
cannot be managed in isolation. Cash flows are results of other activities
taking place in the company. All cash management procedures must be
tailored to meet the cash needs of the operating cycle of the company – not
the other way round. A company cannot normally be asked to alter its normal
course of business to suit its cash manager. This is a big challenge which can
only be met through meticulous planning, carefully drawn procedures and
quick action by finance manager at the appropriate time.

The Main Objectives of Cash Management Policy

What does a finance manager expect of get out of a cash management
policy? Essentially, a company aims at two things: that it is never short of
cash and that it never has too much idle cash. Thus the objectives of the cash
management policy are:

a. The company should be able to meet all its payment obligations on

due dates so as not to lose any goodwill. This is extremely important. If
a company fails to pay its (trade or other) creditors on time, it will lose
goodwill which in turn can expose it to several other risks, including
inability to get supplies on time, recalling of its loans before due date,
etc. In order to accomplish this objective, a finance manager must
carefully chart out the company’s cash operating cycle, so as to be
aware of the times when there is likely to a be a cash shortage. Once
the timing and magnitude of the likely shortage are known, suitable
arrangements can be made in advance to avoid the shortage and its
negative consequences.

b. The amount of idle cash held should be minimized. Idle cash is a waste
of resources. Just as preparation of cash flow plans can indicate the
times when a company may experience cash shortages, it can also
divulge the times when there is likely to be cash surpluses. If the
finance manager knows the timing and the duration for which cash is
likely to remain idle, he can put it to alternative use, thereby
generating some income.

How much cash should be held?

Much like stocks and debtors, the level of cash to be held depends on the
balance between cost of holding cash and the benefits to be obtained from
holding cash. However, one thing to remember here is that cash is not a
commodity like stock that can be bought whenever a need arises for it, nor
can it be disposed of without incurring a loss. Hence, the importance of
planning cash flows. Another important aspect is the form in which cash
should be held, i.e. what portion of the available cash should be held in the
form of physical cash, in current account, in short term deposits, or as
marketable securities. The answer to this can be provided by the cash
planning exercise discussed later in this chapter.

Cost of Keeping Cash

The costs of keeping idle cash are:
a. As already pointed out, idle cash attracts cost of capital. It is naïve to
think that only borrowed funds have a cost. As a student of finance,
you will by now be able to appreciate that any resource put at the
disposal of the company has a cost.

b. In addition, cash loses value over time due to inflation.

c. Cash lying in company’s safe or current bank account also deprives the
company of the profit that it could make by investing it elsewhere. This
is the opportunity cost of idle cash.

d. If surplus cash in held in the form of marketable securities, these may

lose value due to market fluctuations. The possibility of loss due to an
element of uncertainty also applies to funds held in the shape of
foreign currencies as they are equally liable to lose value.

Benefits of Keeping Cash

The benefits of keeping a healthy cash balance are:

a. It saves the company from the effects of cash shortages. As stated

earlier, cash shortage results in a failure to meet one’s payment
obligations on time. This leads to getting poor treatment from
suppliers, having to pay higher prices, inability to get adequate credit,
failure to get stocks when these are in short supply as sellers prefer to
serve the better paymasters, etc. All these things translate into costs
which can be saved by having sufficient cash to meet routine payment
liabilities.

b. If a company pays its lenders on time, it is likely to get a reduction in

interest rates when these come up for revision, or easily get an
extension in credit volume. Better goodwill and improved credit ratings
follow. These lead to lower cost of borrowed funds for the company in
the future.

c. Adequate cash balances make it possible for the company to avail cash
discounts offered by the supplier. Experience shows that cash discount
is generally offered by companies in financial difficulties. Hence, the
effective rate of cash discount is generally above the cost of capital for
the paying companies.

How can a company improve its cash position

Cash position has two active ingredients: inflows and outflows. So essentially
the way to improve the cash position of a company is to speed up its inflows
and slow down its outflows.

Methods of improving Cash Collections

The following methods and techniques are available to companies for
speeding up their collections:
Control Cash Operating Cycle
This is the time it takes a company to collect cash from its operations. It is
the total of average number of days for which raw material, work in process
and finished goods inventories are held plus the average credit allowed to
debtors. One simple way of improving cash position is to try to reduce the
duration of cash operating cycle. This can be done by lowering the level of all
inventories and reducing the credit terms allowed to debtors. As you learned
in previous two chapters, there is limit to which a company can cut down its
inventories and receivables. Going beyond that limit can prove counter-
productive.

Prompt follow up on debtors

Perhaps the largest slice of a company’s cash flows comes from its debtors.
By maintaining a prompt follow up on debtors, a company can improve its
cash position without formally cutting down the credit terms. Follow up
includes timely sending out of invoices and monthly statements of accounts
and maintaining a regular liaison with debtors. For example, if a company
allows 30 days terms to its clients, it must dispatch its monthly statement in
good time and its staff must approach the clients promptly on 30 th day to
collect the cheque. If it is left to the debtors, they might intentionally or
otherwise take a few more days to settle their bills. This is all the more true in
countries like Pakistan where debtors conveniently pretend that if a creditor
does not remind them, he does not need the money. An informal survey has
revealed that by regularly sending staff members to personally collect the
payments from debtors, companies can reduce the average number of days
taken by their debtors to pay by as many as five days.

Prompt banking
A company cannot use its cash unless it has been credited to its bank
account. Hence, it is very important to promptly deposit all the receipts.
Experience in Pakistan has shown that inefficient firms take two to three days
to take their deposits to the bank, whereas efficient companies bank their
receipt two to three times a day. Considering that most banks offer evening
banking service, there is no justification for delaying deposits even for a day.

Concentration banking
This refers to an arrangement whereby a company opens bank accounts in all
the various towns where it has customers. All customers are asked to send
their remittances to the bank in their respective town, or the staff members
are asked to personally collect the cheques and deposit them with the bank
in their town. Each bank in such towns is given specific instruction that all
collections must be sent to the head office account, every day. In this way,
the company saves the time taken by postal services to deliver the cheque
from a customer to the head office of the company. Today’s banks are
equipped with latest information technologies. They are capable of providing
instant credit at the head office for deposits made in different towns. This can
greatly assist the company in improving its cash position.

Selling off your receivables

This refers to an arrangement whereby a creditor can get cash against his
trade receivables from a financial institution – by of course foregoing a part of
them as interest. This can take a number of different forms, e.g. simply
pledge the trade debtors and get a loan, or transfer the right of receiving
money from trade debtors to the financial institution with or without retaining
basic responsibility for repayment. In this way, by foregoing a small portion of
the debtors (interest on the facility) a company can effectively turn all its
credit sales into cash sales. Unfortunately, such discounting facilities are not
widely available to businessmen in Pakistan. The reason banks are not keen
at providing finance against receivables is the lack of proper credit rating
system in the country. If the debtors are rated by an independent credit
rating agency, banks are able to evaluate the risk of accepting debtors as a
security for providing cash to the creditor, and accordingly set the interest
rate. There are at least two credit rating agencies in the country but the
common businessmen are not prepared to get themselves rated as most of
them are unable to meet the documentary and audit requirements of the
agencies. However, with the passage of time, it is hoped that more and more
businessmen will learn the benefits of streamlining their systems, applying
for credit rating and getting better treatment from their suppliers. In turn,
this will enable the suppliers to provide them with longer credit terms as
suppliers will be in a position to get their receivables discounted by banks.

Offer Cash Discounts

This can help a company improve its collections from debtors. As long as the
discounts offered do not cost the company more than its cost of funds, it
makes sense to offer discounts and collect receivables within a short period.

Methods of controlling cash outflows

A company can use the following methods to slow down cash outflows
without damaging its goodwill or credit rating:

Negotiate better terms with suppliers

Skilful negotiations with creditors to increase the credit period can help a
company vastly improve its cash position. Wholesalers, particularly in
pharmaceutical industry, are known to negotiate up to 90 days credit from
manufacturers while extending only 20 to 30 days credit to their own clients.
In this way, they manage to operate their business without any investment in
working capital at all. However, duration of credit period depends on a
number of factors and all of these factors must be taken into account before
deciding how much credit to avail. As it is often said, there is no free lunch in
business. A supplier who is willing to offer longer credit terms will certainly
compensate himself with higher prices.

Take full benefit of credit period

Once a credit period has been agreed with a supplier, payment should not be
made before the expiry of that period. Even small amounts should not be
paid before the due date. It is a question of financial discipline that payments
must be made only when due. Paying a creditor before time does not earn
the company any goodwill or a financial reward; so there is no justification for
it.
Issue cheques from other towns / play the float
One way to delay payment to creditors without being accused of doing so is
to issue them cheques from different towns. For example, a supplier in
Karachi should be sent a cheque drawn on an Islamabad branch. In this way,
money will stay in company’s accounts till the cheque is presented, four or
five days later, to Islamabad bank. This is often called playing with float.
However, with banks offering fast collection services and internet banking,
playing with float is becoming a thing of the past.

Centralized payments
Perhaps one of the most effective way of controlling cash outflows is to have
a centralized payment system. All payments (beyond a certain minimum,
say, Rs. 2,000) should be made only by the head office. In this way, the
finance department remain fully aware of its payment obligations and can
plan to meet them in an orderly manner. If branches or sub-offices are
allowed to make their own payments, the company as a whole loses the
ability to prioritize its cash outflows. For example, Peshawar branch may
make a large relatively less important payment without knowing that
Faisalabad branch needs to make a crucial payment and is missing funds for
it. A centralized payment system takes care of these problems.

What to do with surplus Cash

If a company manages its cash well enough, it is likely to be in the happy
position of having surplus cash at certain times of the financial year. Making
productive and prudent use of surplus cash can add to the profits of the
company. When considering alternative use of surplus cash available to the
company, the most important factor to consider is the duration for which the
surplus cash is available. This can be ascertained by drawing up proper cash
budgets (discussed later in this chapter). For example, a company dealing
mainly with summer related items (e.g. an electric fans manufacturer) may
find surplus cash in the months of summer, but this surplus may not last for
more than a few months. Hence, it cannot be invested in any long term
project. However, in certain cases, the cash budget may disclose that a
certain amount of cash will be in excess of normal operational needs
throughout the year. In such a case, long term usage of that amount can be
contemplated.

Uses of Short Term Cash Surplus

If surplus cash is available for only a short period, at the end of which it will
be needed for routine purposes, it can be invested in any of the following
ways:

a. Placing the money in savings account that carries some interest rate.
b. Placing the money in short term deposit accounts (say for three or six
months) that generally carry better rate of interest than savings accounts.
c. Buying marketable securities carrying some rate of return, or an
expectation of profit through increase in market value.
d. Buying short term treasury bills. However, in Pakistan treasury bills can
only be bought by financial institutions and are generally sold in very
large lots.
e. If the surplus amount available is large enough, it can be placed in the
call market in Karachi. Generally placements in call market – a market for
short term deposits – can only be done through banks and other financial
institutions. Placements by common businessmen at the call market are
quite rate.

Uses of Long Term Cash Surplus

If the cash budget shows that a company will have a consistent cash surplus
throughout a financial year, it can mean that a company can safely remove
that much cash from the current assets part of its investments and use it for
other than normal operational needs. These could include:

a. Paying dividends to shareholders. Assuming that payment of normal

end of the year dividend is already provided for in the budget,
availability of permanent cash surplus can enable a company to pay
interim dividends – thereby enhancing its markets posture and share
value.

b. Prepaying long term loans. It is to be believed that normal loan

repayments will be built into the cash budget. If the budget still shows
long term cash surplus, it makes sense to prepay the more expensive
long term loans off, thereby savings interest costs.

c. Buying fixed assets or initiating new projects. This can generate more
profits for the company by increasing its productive capacity.

How to Cope with Cash Shortages

If the cash budget shows that the company is likely to experience a cash
shortage at any time during the financial year, it is necessary to make
arrangements well in advance to meet such a shortage. Well-planned
borrowing can be cheaper and safer for the company. However, when making
arrangements for meeting anticipated cash shortages, the most important
factor to consider is the duration of the shortage. Arrangements to be made
to handle short term shortages may be quite different from those needed for
long term shortages.

Meeting Short Term Shortfalls

Short term shortages are taken to be those that arise only for a part of the
financial year. Cash generated from the normal operations of the company in
periods following the shortfall is able to wipe off the deficit during the same
financial year. So the company needs to make arrangements for only a short
period of time. The following alternatives are generally available for this
purpose:
a. Negotiations may be made with the suppliers to enhance the credit
period. This will generally carry a lower cost and lesser hassle than is
involved in documentation and securitization of loans from financial
institutions.

b. If the cash budget shows a capital expenditure during the months of cash
shortfall, it can be deferred till the cash position improves. In certain
cases, this may not be possible but where it is possible, this appears to be
the least painful of alternatives.

c. The last recourse is to borrow short term funds from banks or other
financial institutions. Several forms of borrowing are available including:
o Running finance facility (also known as overdraft). Under this
arrangement, bank allows the customer to overdraw his current
account up to a stated limit. Interest is charged only on the actual
outstanding balance at the end of each day.
o Short term loan for a fixed period. Under this arrangement, bank
disburses the entire amount of the loan at the beginning of the credit
period and charges interest on the whole amount for the entire period
of credit.
o Function-specific facilities like import finance, export finance, raw
material pledge finance etc.

Most companies that have seasonal business make these short term
financing arrangements well in advance so that when the crunch months
arrive, they are all ready to handle the situation.

Handling Long Term Cash Shortfalls

If the cash flow projections, i.e. the cash budgets, show a persistent cash
short fall through out the financial year, this simply means that the company
has not invested sufficient long term funds in working capital. One good
preliminary step to take is to prepare cash forecasts for more than one year –
say for three to five years. If these show cash shortfall to continue over a
sustained period, the only solution is to inject permanent funds. These could
either be equity funds raised through issuing new shares or long term debt
from a financial institution or issue of bonds to general public.

Cash Budgeting
Preparation of a cash budget is perhaps the most potent tool available to
financial managers for managing their cash flow situation. It helps them see,
with some degree of accuracy, the cash balance position at the end of each
planning period, generally a month. This gives them sufficient time to make
arrangements for meeting the projected shortfalls or investing the expected
surpluses. It also helps them move around major receipt and payment events
in order to synchronise them. For example, if a major capital expenditure is
being planned for April but the cash budget shows insufficient funds
availability in that month, it may be possible to reschedule the capital
expenditure to a month when adequate funds are likely to be available.
Similarly, if say July shows availability of surplus funds, certain major
payments like interim dividends, can be brought forward.

Purpose of Cash Budgeting

The main purpose of cash budgeting is:
o To forewarn the management of likely shortfall and/or surplus situations in
the financial period.
o To synchronize cash inflows and outflows where possible in order to
minimize interest costs and optimize investment income.
o To let every manager know of his respective responsibility in relation to
cash management. For example, a cash budget may clearly lay down the
collection targets for sales staff to ensure that cash flow from debtors
remains within planned parameters. Similarly, expenses are controlled by
setting payment limits for each period.
o When preparing the cash budget, input is sought from all relevant
managers like sales staff, credit control staff, supplies staff, inventory
controllers, production planners, etc. This therefore helps in coordinating
the activities of various departments with the objective of meeting the
common goal of the company, namely enhancing profits.

Budget Period
Cash budgets are generally prepared for one year at a time, broken down by
months. A typical cash budget will have 13 columns, one for each month and
the last for the total year. Some larger companies may even prepare weekly
cash budgets but there are only a few who need to go to that detail. As a
matter of routine, cash budgets are prepared annually but revised twice or
thrice during the year, or upon occurrence of a major event impacting the
cash flows.

Cash Budget Format

A cash budget is generally prepared on the same basis as a company writes
its cash book. It has two major sections: receipts and payments. Each major
source of receipt (e.g. cash sales, receipts from debtors, other incomes, etc.)
is given a separate line, with a total receipts line at the end of this section.
Similarly, each major payment head (e.g. creditors, various overheads,
capital expenditure, etc.) is given a separate line, with a total payments line
at the end of this section. Three further lines follow: the first showing the
deficit or surplus for the month, the second showing balance brought forward
from the previous period, and the last showing balance being carried forward
to the next period.

Practical Steps in Cash Budgeting

Procedures for preparing a cash budget differ from company to company.
Some make very elaborate arrangements, with the process lasting several
weeks, while others may carry out the exercise in an informal manner.
However, the following are essential steps that must be gone through to
ensure that the resultant cash budget is reliable.

Stage 1 Estimate Sales Revenue

This is done in the following distinct steps:

Step 1 Estimate Sales Volumes

The starting point is always the estimate of sales quantities. It is the sales
volume on which all other actions of the company are based. Estimates for
sales quantities of each product for each period must be agreed upon by all
concerned (like marketing, production and finance staff, etc.) after a
thorough discussion between them on all related matters like market
conditions, economic situation, seasonality of sales, etc.

Step 2 Setting Sales Prices

Once the sales volumes for each month of the budget year have been agreed
upon, the next step is to decide the sales prices. This stage also includes
consideration of trade discounts, quantity discounts, stock write off prices,
etc. After the sales prices have been decided, sales revenue can be worked
out by multiplying sales quantities for each product with relevant prices.

Step 3 Estimate Sales Compositions

This means making estimate about what portion of the sales will be sold for
cash, and what on credit. Again, out of the credit sales what portion will be
collected within what period. This is important as it will impact on when the
actual sales revenue will be collected in the form of cash.

Stage 2 Estimate other receipts

In addition to revenue from sales, a company may also receive cash from
certain other sources like:
• Income from rent or dividends on investments, interest on deposits, etc.
• Raising long term loans,
• Sale of fixed assets,
• Issue of new shares, etc.

Some of the above are fixed in terms of time, i.e. as to when they will be
received. Examples of such receipts are interest on deposits which are
credited by banks on pre-set dates, dividends on shares held, rent on
properties, etc. Certain others receipts may have some flexibility and it may
be possible to shift them around to suit the need of cash flow management,
e.g. sale of a fixed asset may be scheduled when cash flow projections show
a shortfall.

Stage 3 Estimate Payments for Production and Expenses

A detailed discussion on components of cost of production is outside the
scope of this elementary text. However, briefly, estimates need to be made
about cost of raw material and packaging materials to be used, cost of direct
labour and cost of various factory related expenses called production
overheads. The following steps are involved:

Step 1 Raw Materials

When making estimate of raw material and packing material costs, it is
important to include the following:

• Estimate the quantity and price of each raw material item to be used for
each of the products to be manufactured and sold over the budget period.
• How will the production be carried out? For example, will it be based
strictly on sales quantities for each period, or will it be independent of
each period’s sales.
• Once the production plan is worked out, the next step is to estimate when
the raw materials will be actually bought. Will these be acquired in the
month of production or some time before it? Will certain stock levels be
necessary to be maintained due to seasonal availability?
• Once the raw materials purchase plan is agreed, the next step is to
establish the credit terms that will be received from the suppliers. This will
clearly determine the timing and volume of the cash outflows on this
account.

Step 2 Direct Labour

While most accounting and costing books define direct labour as a variable
cost, the practice in Pakistan shows that wages paid to workers are fairly
fixed in nature. Most workers are nowadays paid on the basis of time and not
on piecemeal rate. Hence, estimates of labour cost are generally made on the
same basis as administrative salaries, i.e. as a time related cost and cash
outflow.

Step 3 Production Expenses

The next step is to estimate the various production related expenses like
energy cost, machinery maintenance, repairs, stores and supplies, factory
rent and rates, etc. Some of these expenses may be paid in advance, some in
the month of production and some a while after the month of production. This
division must be carefully estimates as it will impact the timing and volume of
cash outflow on this account.

Step 4 Estimate Other Overheads

These include administration related expenses, sales, marketing and
distribution related expenses and financial expenses. While most of these
expenses are time related and may be divided evenly over the various
months of the budget year, some may be paid later than others. For example,
cost of placing advertisement in newspapers or television is often paid one to
two months after the appearance of the adverts. All these factors should be
considered when estimating the amount and timing of payment of these
expenses.

Stage 4 Estimate Other Payments

These include payments for non-routine expenses like repayment of long
term loans, purchase of fixed expenses, dividend payments, redemption of
shares or bonds, etc. Some of these payments are compulsory and must be
made on specified dates, e.g. loan repayments, while others can be shifted
around to suit the cash flows. For example, purchase of a fixed asset or
payment of interim dividends can be scheduled for a month that has
adequate cash balance.

Stage 5 Balance the Cash Budget

This involves finding out the cash deficit or surplus for each month, adding it
to the opening balance and finding out the closing balance. Many companies
prefer to keep a certain minimum balance at the end of each month for
precautionary and speculative reasons. Hence, if the closing balance as
projected by the cash project appears to be less than the desired minimum
balance, arrangements are needed to meet the shortfall. One way of handling
these shortfalls is to shift around the discretionary receipts and payments.
For example, a planned issue of shares may be moved forward, or a capital
expenditure may be delayed. If the shortfall still persists, it calls for an
external arrangement like obtaining a running finance facility from a bank.

On the other hand, if the closing cash balance being projected by the cash
budget is significantly more the minimum balance required to be maintained,
some shuffling around of discretionary receipts and payments may be done
to eliminate idle cash, e.g. payment of interim dividends may be brought
forward, some loans be prepaid, issue of new shares may be delayed, etc.

Balancing the cash budget stage is the most important part of preparing the
budget. This enables the finance manager to synchronize receipts and
payments which is one of the principal advantages of and reasons for
preparing a cash budget. Once the desired closing balance for each month of
the budget year has been reached, the budget should be sent for approval by
appropriate authorities. After the approval, it should be implemented. While
unforeseen events and matters outside the control of a company may cause
projected collections or payments to be more or less than the budgeted
amounts, efforts should be made to stay as close to the budget as possible to
ensure that the basic objective of the cash planning is met: namely to meet
all payment obligations in time and not to have idle cash at any time.

The following chart lists the stages involved in cash budgeting.

CASH BUDGETING PROCESS

a. Sales quantities for each product for each month

Estimate b. Sale prices, discounts, etc.
Stage I Sales c. Sale revenue for each month
Revenue Collection pattern, i.e. how much of each month’s sales
d.
will be received in cash in what month

Income from rent or dividends on investments, interest on

a.
Estimate deposits, etc.
Stage 2 Other b. Raising long term loans,
Receipts c. Sale of fixed assets
d. Issue of new shares, etc.

Stage 3 Estimate a. Raw material usage, prices and purchase timings.

Payments b. Payment pattern, i.e. how much of each month’s
for expenses purchases will be paid for in cash in what month
 c. Direct labor costs and payment timings
d. Production related expenses and their timings
e. Other overheads and their timings

a. Long term loan repayments

Estimate
b. Capital Expenditure
Stage IV Other
c. Dividend payments
Payments
d. Redemption of shares or bonds

Find the deficit or surplus for the month, add it to opening

a.
balance to establish projected closing balance
Balance Shuffle around discretionary receipts and payments in
b.
the order to obtain desired closing balance for each month
Stage V
Cash If internal sources are not adequate, make external
c.
Budget sources for meeting the deficit
Re-balance the cash budget, get it approved and
d.
implement it.

Example
Gujrat Electric Fan Co. manufactures a single product.

a. Its projected sales for the last two months of 2006 and the first six
months of 2007 are as follows:

November 2006 8,000 units

December 2006 6,000 units
January 2007 6,000 units
February 2007 8,000 units
March 2007 10,000 units
April 2007 12,000 units
May 2007 14,000 units
June 2007 14,000 units

b. Fans are sold for Rs 360 each. However, the company proposes to
increase the selling price by 5% with effect from 1 March 2007.

c. 10% of the sales are against cash to small traders. 60% of the credit
sales are paid for within a month and 38% of the credit sales within
two months. The remaining 2% of credit sales are deemed
irrecoverable.

d. Items are manufactured in the month preceding the month of sale.

Thus units to be sold in March 2007 will be manufactured in February
2007.

e. Raw material cost per fan is expected to be Rs 200 per unit till the end
of March 2007. After that it will rise by 5%. Raw material is bought in
the month preceding the month of production. All purchases are on 60
days credit terms.

f. Details of production overheads are as follows:

 o Direct Labour Rs 220,000 per month, paid in the month incurred
o Electricity, at Rs. 6 per unit manufactured, paid in the month
following the production.
o Plant maintenance, Rs 80,000 per month, paid in the month
incurred.
o Depreciation, Rs 2,500,000 per annum.
o Other production expenses, Rs 120,000 per month, paid in the
month incurred

g. Details of other overheads are as follows:

o Office administration, Rs. 350,000 per month, paid in the month
incurred
o Marketing and distribution expenses, 8% of sales paid in the month
of sales.

h. The company has a long term loan which is being repaid by quarterly
installments of Rs. 850,000 in the second month of each calendar
quarter.

i. The company plans to purchase a new machine in June at a total cost

of Rs. 5.0 million. 30% of its price will be paid by the company and the
rest will be financed by a leasing company. Repayments to lease
company will start in the last quarter of the year.

j. A part of company’s buildings is sub-let to a tenant who pays rent of

Rs. 80,000 per quarter, at the end of each calendar quarter.

k. The company maintains a minimum cash balance of Rs 100,000, which

is expected to be the opening balance on 1 January 2007. Any cash in
excess of this balance is transferred to a savings account that earns
6% interest. However, all transfers to savings account are in multiples
of Es 100,000.

l. The company wishes to pay a dividend of Rs 1,000,000 after March

2007.

Prepare a Cash Budget for the first half of 2007, advising the company on the
following issues:
o The most appropriate time to pay the dividend.
o Does the company need to make any prior arrangements with its
bankers?

Solution:

Step 1: Estimate the amount of sales in each month.

Sales are given in quantities. The unit price applicable in January 2007 is also
given. It has been said that sales price will go up by 5% in March 2007.
Since, actual receipt of sales proceed will involve sales made in two previous
months, we will need to estimate sales revenue for the last two months of
2006 as well as the first six months of 2007.

Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

Sales Qtty,
8,000 6,000 6,000 8,000 10,000 12,000 14,000 14,000
units
Selling
Price, 360 360 360 360 378 378 378 378
Rs/unit
Sales
2,880,0 2,160, 2,160, 2,880,0 3,780,0 4,536,0 5,292,0 5,292,0
Revenue,
00 000 000 00 00 00 00 00
Rs

Step 2: Calculate the amounts of cash and credit sales.

o 10% of each month’s sales are against cash. These will be collected in the
month of sale.
o 90% of each month’s sales are on credit.
o Hence, the division of sales into cash and credit sales will be as follows:

Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

2,880,0 2,160,0 2,160,0 2,880,0 3,780,0 4,536,0 5,292,0 5,292,0
Total Sales
00 00 00 00 00 00 00 00
Cash 288,00 216,00 216,00 288,00 378,00 453,60 529,20 5,29,20
Sales, 10% 0 0 0 0 0 0 0 0
Credit 2,592,0 1,944,0 1,944,0 2,592,0 3,402,0 4,082,4 4,762,8 4,762,8
Sales, 90% 00 00 00 00 00 00 00 00

Step 3: Estimate the amount of cash to be collected each month

from cash as well as credit sales.
o 10% of each month’s sales will be collected in cash.
o 60% of each month’s credit sales will be collected in cash in the following
month. Hence, 60% of December 2006’s credit sales will be collected in
January 2007.
o 38% of credit sales will be collected two months later. Hence, 38% of
November 2006’s credit sales will be collected in cash in January 2007.
o 2% of each month’s sales will be lost by way of bad debts. These will not
appear any where in the cash budget.
o Hence, actual cash collection from cash and debtors in each month will be
as follows:

Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

216,00 288,00 378,00 453,60 529,20 5,29,20
Cash Sales
0 0 0 0 0 0
1,166, 1,166, 1,555, 2,041,2 2,449,4 2,854,6
60% of Last Month’s Credit Sales
400 400 200 00 40 80
38% of Previous to Last Month’s 984,96 738,72 738,72 984,96 1,292,7 1,551,3
Cr. Sales 0 0 0 0 60 12
2,367, 2,193, 2,671, 3,479,7 4,271,4 4,938,1
Total Collection for Sales
360 120 920 60 00 92

Step 4: Estimate other income and receipts.

o There are only two other receipts.
o Rent income of Rs 50,000 will be received in March and June 2007.
o A lease finance loan of Rs 3,500,000 will be received in June 2007.
o Hence, other receipts will be as follows:

May
Jan 07 Feb 07 Mar 07 Apr 07 Jun 07
07
Rental Income 50,000 50,000
3,500,0
Lease Finance Loan
00

Step 5: Estimate the cost of raw material to be used.

o In order to calculate the cost of raw material to be used, first we need to
ascertain each month’s production.
o It is given that each month’s actual production will be equal to next
month’s sale. Thus production in Jan 2007 will be equal to units to be sold
in Feb 2007.
o Raw material is to be bought one month before production. This means
units to be sold in March 2007 will be manufactured in February 2007 but
raw material for these units will be bought in January 2007. Applicable
price is Rs 140 per unit, going up to Rs 147 w.e.f. April.
o We are also told that payment for raw materials is to be made within 2
months. This means payment to be made in January 2007 will be in
respect of raw material bought in Nov. 2006.
o The above information can be tabulated as follows:

Raw Payment
No. of Price of
No. of Material Total Raw to be made
Units Raw
Month Units bought for Material for
To be Material
To be sold how many Purchase Raw
Made Rs/unit
Units Material
November
8,000 6,000 6,000 140 840,000
06
December
6,000 6,000 8,000 140 1,120,000
06
January 07 6,000 8,000 10,000 140 1,400,000 840,000
February
8,000 10,000 12,000 140 1,680,000 1,120,000
07
March 07 10,000 12,000 14,000 140 1,960,000 1,400,000
April 07 12,000 14,000 14,000 147 2,058,000 1,680,000
May 07 14,000 14,000 16,000 147 2,352,000 1,960,000
June 07 14,000 16,000 12,000 147 1,764,000 2,058,000
July 07 16,000 12,000
August 07 12,000

Step 6: Estimate labor expense.

o Labour expense is given as a flat Rs 200,000 per month for Jan to Mar
2007 and increasing to Rs 242,000 (i.e. a 10% rise) with effect from April
2007.
o This can be tabulated as follows:
 May
Jan 07 Feb 07 Mar 07 Apr 07 Jun 07
07
220,00 220,00 220,00 242,00 242,00 242,00
Labour Expense
0 0 0 0 0 0

Step 7: Estimate Electricity Expense.

o Electricity expense is given as Rs 6 per unit. Hence, we need to ascertain
the units to be produced in each month (as shown in Step 5 above) and
multiply them with cost of electricity per unit.
o Payment for electricity is to be made in the month following the month of
production.

May
Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 Jun 07
07
Production, units 6,000 8,000 10,000 12,000 14,000 14,000 16,000
Cost Rs/unit 6 6 6 6 6 6 6
Total Electricity
36,000 48,000 60,000 72,000 84,000 84,000 96,000
Cost
Electricity Paid 36,000 48,000 60,000 72,000 84,000 84,000

Step 8: Estimate other expenses.

o Plant maintenance, other production expenses and office administration
expenses are fixed and to be paid in the month incurred. These can be
tabulated straight as given.
o Marketing expenses are given as 5% of month’s sales. Sales for each
month were computed in Step 1 above. Marketing expenses will be simply
5% of that figure.
o Depreciation is a non-cash expense and does not appear in the cash
budget.
o Hence, all other expenses can be tabulated as follows:

May
Jan 07 Feb 07 Mar 07 Apr 07 Jun 07
07
Plant Maintenance 80,000 80,000 80,000 80,000 80,000 80,000
120,00 120,00 120,00 120,00 120,00 120,00
Other Production Expenses
0 0 0 0 0 0
350,00 350,00 350,00 350,00 350,00 350,00
Office Administration Expenses
0 0 0 0 0 0
Market & Dist. (5% of month’s sales 108,00 144,00 189,00 226,80 264,60 264,60
revenue) 0 0 0 0 0 0

Step 9: Estimate other payments

o Repayment of long term loan is in two installments, of Rs 850,000 each, in
February and May 2007.
o A new machine is to be bought in June 2007 for Rs 5,000,000. Since, we
will be showing the loan from Lease Company as receipt, we should show
the entire cost of new machine as payment in the cash budget.
 May
Jan 07 Feb 07 Mar 07 Apr 07 Jun 07
07
850,00 850,00
Long Term Loan repayment
0 0
5,000,0
Purchase of New Machine
00

Step 10: Now arrange the above information in the form of Cash
Budget and balance it.
o Note that opening balance is given as Rs 100,000.
o Our advice on payment of dividends or prior arrangements with bankers
will be based on balances of cash shown at the end of each month by the
cash budget.

CASH BUDGET
Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07
Receipts
216,00 288,00 453,60 529,20 5,29,20
Cash Sales (Step 3) 378,000
0 0 0 0 0
60% of Last Month’s Credit Sales 1,166,4 1,166,4 1,555,2 2,041,2 2,449,4 2,854,6
(Step 3) 00 00 00 00 40 80
38% of Prev to Last Month’s Cr 984,96 738,72 984,96 1,292,7 1,551,3
738,720
Sales (Step 3) 0 0 0 60 12
2,367,3 2,193,1 2,671,9 3,479,7 4,271,4 4,938,1
Total Collection for Sales (Step 3)
60 20 20 60 00 92
Rental Income (Step 4) 50,000 50,000
3,500,0
Lease Finance Loan (Step 4)
00
2,367, 2,193, 2,721, 3,479, 4,271, 8,488,
Total Receipts
360 120 920 760 400 192

Payments
840,00 1,120,0 1,400,0 1,680,0 1,960,0 2,058,0
Raw Material (Step 5)
0 00 00 00 00 00
220,00 220,00 242,00 242,00 242,00
Labour Expense (Step 6) 220,000
0 0 0 0 0
Electricity Expense (Step 7) 36,000 48,000 60,000 72,000 84,000 84,000
Plant Maintenance (Step 8) 80,000 80,000 80,000 80,000 80,000 80,000
Other Production Expenses (Step 120,00 120,00 120,00 120,00 120,00
120,000
8) 0 0 0 0 0
350,00 350,00 350,00 350,00 350,00
Office Admin Expenses (Step 8) 350,000
0 0 0 0 0
108,00 144,00 226,80 264,60 264,60
Marketing & Distribution (Step 8) 189,000
0 0 0 0 0
Long Term Loan Repayment 850,00 850,00
(Step 9) 0 0
Purchase of New Machine (Step 5,000,0
9) 00
1,818, 3,018, 2,532, 2,906, 4,109, 8,357,
Total Payments
800 400 400 880 360 360

548,56 (825,28 572,88 162,04 130,83

Balance for the month 189,520
0 0) 0 0 2
100,00 648,56 (176,72 585,68 747,72
Balance brought forward 12,800
0 0 0) 0 0
 648,56 (176,72 585,68 747,72 878,55
Balance carried forward 12,800
0 0) 0 0 2

Step 11: Advice to the Company.

o Dividends cannot be paid in the first half of 2007 as the company does not
have a cash balance in excess of Rs 1,000,000 in any month.
o The company will have a negative cash balance at the end of February
2007. Again, it will have less than the required minimum balance in March
2007. It must therefore make prior arrangements for an overdraft with its
bankers for these two months. Alternatively, it may negotiate extended
terms from creditors for these months.

KEY TERMS

o Transactional motive
o Precautionary motive
o Speculative motive
o Near Cash
o Potential Cash
o Cost of idle cash
o Cash operating cycle
o Concentration banking
o Playing the float
o Cash Budgeting
o Budget period
o Discretionary receipts and payments
o Synchronization of receipts and payments

QUESTIONS

1. Discuss the reasons or motives for keeping cash. Which of these motives do you
consider the most important? Why?

2. Explain the difference between the terms cash, near cash and potential cash,
giving examples in each case.

3. What is meant by a cash management policy? What are the advantages of

drawing up one?

4. Discuss the contents of a cash management policy of a small scale

manufacturing company.

5. Discuss the statement, “The biggest problem of cash management is that cash is
 the result of activities carried out by other persons, not the cash manager”. How
do you propose this problem can be tackled?

6. What factors govern the level of cash to be maintained at any given time?

7. Discuss the methods of improving the cash inflows, clearly outlining the
limitations of each method.

8. Discuss the methods of controlling or regulating cash outflows, clearly outlining

the limitations of each method.

9. How may company handle cash surplus that are available for (a) a short period
only (b) long term period?

10 How may a company cope with cash short falls that are (a) short term or (b) long
. term in nature?

11 What is meant by cash budgeting? Discuss the various factors that influence the
. process of cash budgeting.

12 What is meant by (a) Budget Period (b) Budget Format

.

13 Prepare a cash budget for Tightcash Private Ltd from the following information:
.

Estimated sales, purchases and expenses etc. are:

May 07
All figures in millions of Rs. July 07 Aug 07 Sept 07 Oct 07 Nov 07 Dec 07
& June 07

Sales 350 400 400 500 550 600 650

Purchases 140 160 170 200 250 250 280

Wages and Salaries 120 140 140 180 158 200 220

Misc. Expenses 50 60 60 60 75 75 75

Rental Income 20 20

Issue of Shares 200

o 20% of sales are on cash and the rest on credit. Cash sales are allowed 1% cash
discount.
o 50% of credit sales are collected in 30 days and 48% in 60 days. The rest are bad
debts.
o Creditors for purchases are paid after 60 days. All other expenses are paid in the
month they are incurred.
o A minimum cash balance of Rs 50 million is expected to be retained at all times.
o A fixed asset costing Rs 30 million is to bought in any month that shows surplus
above the minimum balance.