10.

34 FINANCIAL MANAGEMENT

UNIT - II
TREASURY AND CASH MANAGEMENT

10.7 TREASURY MANAGEMENT: MEANING

In the wake of the competitive business environment resulting from the
liberalization of the economy, there is a pressure to manage cash scientifically. The
demand for funds for expansions coupled with high interest rates, foreign exchange
volatility and the growing volume of financial transactions have necessitated
efficient management of money.
Treasury management encompasses planning, organizing & controlling the funds
& working capital of an enterprise in order to ensure best use of funds, maintain
liquidity, reduce overall cost of funds and mitigating operational & financial risk. It
involves the corporate handling of all financial matters, the generation of external
and internal funds for business, the management of currencies and cash flows and
the complex, strategies, policies and procedures of corporate finance.
The treasury management mainly deals with:-
 Working capital management; and
 Financial risk management (It includes forex and interest rate management).
The key goals of treasury management are:-
 Maximize the return on the available cash;
 Minimize interest cost on borrowings;
 Mobilise as much cash as possible for corporate ventures for maximum
returns; and
 Effective dealing in forex, money and commodity markets to reduce risks
arising because of fluctuating exchange rates, interest rates and prices which
can in turn affect the profitability of the organization.

10.8 FUNCTIONS OF TREASURY DEPARTMENT

The treasury department have evolved in importance over number of years from
being responsible for only cash handling issues to technical areas revolving around
hedging forex risks, composition of capital structure etc. The fundamental tasks for
which treasury department of any enterprise is responsible are :-

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 MANAGEMENT OF WORKING CAPITAL 10.35

1. Cash Management: It involves efficient cash collection process and

managing payment of cash both inside the organisation and to third parties.
There may be complete centralization within a group treasury or the treasury
may simply advise subsidiaries and divisions on policy matter viz.,
collection/payment periods, discounts, etc.
Treasury will also manage surplus funds in an investment portfolio.
Investment policy will consider future needs for liquid funds and acceptable
levels of risk as determined by company policy.
2. Currency Management: The treasury department manages the foreign
currency risk exposure of the company. In a large multinational company
(MNC) the first step will usually be to set off intra-group indebtedness. The
use of matching receipts and payments in the same currency will save
transaction costs and also will save the organization from any unfavorable
exchange movements. Accordingly, Treasury might advise on the currency to
be used when invoicing overseas sales.
The treasury will manage any net exchange exposures in accordance with
company policy. If risks are to be minimized then forward contracts can be
used either to buy or sell currency forward.
3. Fund Management: Treasury department is responsible for planning and
sourcing the company’s short, medium and long-term cash needs. They also
facilitate temporary investment of surplus funds by mapping the time gap
between funds inflow and outflow. Treasury department will also participate
in the decision on capital structure and forecast future interest and foreign
currency rates.
4. Banking: It is important that a company maintains a good relationship with its
bankers. Treasury department carry out negotiations with bankers with respect
to interest rates, foreign exchange rates etc. and act as the initial point of contact
with them. Short-term finance can come in the form of bank loans or through
the sale of commercial paper in the money market.
5. Corporate Finance: Treasury department is involved with both acquisition and
divestment activities within the group. In addition, it will often have
responsibility for investor relations. The latter activity has assumed increased
importance in markets where share-price performance is regarded as crucial and
may affect the company’s ability to undertake acquisition activity or, if the price
falls drastically, render it vulnerable to a hostile bid.

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 10.36 FINANCIAL MANAGEMENT

10.9 MANAGEMENT OF CASH

Management of cash is an important function of the finance manager. It is
concerned with the managing of:
(i) Cash flows into and out of the firm;
(ii) Cash flows within the firm; and
(iii) Cash balances held by the firm at a point of time by financing deficit or
investing surplus cash.
The main objectives of cash management for a business are:-
 Provide adequate cash to each of its units as per requirements;
 No funds are blocked in idle cash; and
 The surplus cash (if any) should be invested in order to maximize returns for
the business.
A cash management scheme therefore, is a delicate balance between the twin
objectives of liquidity and costs.
10.9.1 The Need for Cash
The following are three basic considerations in determining the amount of cash or
liquidity as have been outlined by Lord Keynes, a British Economist:
 Transaction need: Cash facilitates the meeting of the day-to-day expenses
and other debt payments. Normally, inflows of cash from operations should
be sufficient for this purpose. But sometimes this inflow may be temporarily
blocked. In such cases, it is only the reserve cash balance that can enable the
firm to make its payments in time.
 Speculative needs: Cash may be held in order to take advantage of profitable
opportunities that may present themselves and which may be lost for want
of ready cash/settlement.
 Precautionary needs: Cash may be held to act as for providing safety against
unexpected events. Safety as is explained by the saying that a man has only
three friends an old wife, an old dog and money at bank.
10.9.2 Cash Planning
Cash Planning is a technique to plan and control the use of cash. This protects the
financial conditions of the firm by developing a projected cash statement from a

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 MANAGEMENT OF WORKING CAPITAL 10.37

forecast of expected cash inflows and outflows for a given period. This may be
done periodically either on daily, weekly or monthly basis. The period and
frequency of cash planning generally depends upon the size of the firm and
philosophy of the management. As firms grows and business operations become
complex, cash planning becomes inevitable for continuing success.
The very first step in this direction is to estimate the requirement of cash. For this
purpose, cash flow statements and cash budget are required to be prepared. The
technique of preparing cash flow and funds flow statements have been discussed
in Accounting paper at Intermediate level of CA course. The preparation of cash
budget has however, been demonstrated here.
10.9.3 Cash Budget
Cash Budget is the most significant device to plan for and control cash receipts and
payments. This represents cash requirements of business during the budget period.
The various purposes of cash budgets are:-
 Coordinate the timings of cash needs. It identifies the period(s) when there
might either be a shortage of cash or an abnormally large cash requirement;
 It also helps to pinpoint period(s) when there is likely to be excess cash;
 It enables firm which has sufficient cash to take advantage like cash discounts
on its accounts payable; and
 Lastly it helps to plan/arrange adequately needed funds (avoiding
excess/shortage of cash) on favorable terms.
On the basis of cash budget, the firm can decide to invest surplus cash in
marketable securities and earn profits. On the contrary, any shortages can also be
managed by making overdraft or credit arrangements with banks.
Main Components of Cash Budget
Preparation of cash budget involves the following steps:-
(a) Selection of the period of time to be covered by the budget. It also defines
the planning horizon.
(b) Selection of factors that have a bearing on cash flows. The factors that
generate cash flows are generally divided into following two categories:-
(i) Operating (cash flows generated by operations of the firm); and
(ii) Financial (cash flows generated by financial activities of the firm).

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 10.38 FINANCIAL MANAGEMENT

The following figure highlights the cash surplus and cash shortage position over
the period of cash budget for preplanning to take corrective and necessary steps.

10.10 METHODS OF CASH FLOW BUDGETING

A cash budget can be prepared in the following ways:
1. Receipts and Payments Method: In this method all the expected receipts
and payments for budget period are considered. All the cash inflow and
outflow of all functional budgets including capital expenditure budgets are
considered. Accruals and adjustments in accounts will not affect the cash
flow budget. Anticipated cash inflow is added to the opening balance of cash
and all cash payments are deducted from this to arrive at the closing balance
of cash. This method is commonly used in business organizations.
2. Adjusted Income Method: In this method the annual cash flows are
calculated by adjusting the sales revenue and cost figures for delays in
receipts and payments (change in debtors and creditors) and eliminating
non-cash items such as depreciation.
3. Adjusted Balance Sheet Method: In this method, the budgeted balance
sheet is predicted by expressing each type of asset (except cash & bank) and
short-term liabilities as percentage of the expected sales. The profit is also
calculated as a percentage of sales, so that the increase in owner’s equity can
be forecasted. Known adjustments, may be made to long-term liabilities and
the balance sheet will then show if additional finance is needed (if budgeted
assets exceed budgeted liabilities) or if there will be a positive cash balance
(if budgeted liabilities exceed budgeted assets).
It is important to note that the capital budget will also be considered in the
preparation of cash flow budget because the annual budget may disclose a need

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 MANAGEMENT OF WORKING CAPITAL 10.39

for new capital investments and also, the costs and revenues of any new projects
coming on stream will need to be incorporated in the short-term budgets.
The Cash Budget can be prepared for short period or for long period.
10.10.1 Cash budget for short period
Preparation of cash budget month by month would require the following estimates:
(a) As regards receipts:
1. Receipts from debtors;
2. Cash Sales; and
3. Any other source of receipts of cash (say, dividend from a subsidiary
company)
(b) As regards payments:
1. Payments to be made for purchases;
2. Payments to be made for expenses;
3. Payments that are made periodically but not every month;
(i) Debenture interest;
(ii) Income tax paid in advance;
(iii) Sales tax or GST etc.
4. Special payments to be made in a particular month, for example,
dividends to shareholders, redemption of debentures, repayments of
loan, payment of assets acquired, etc.
Format of Cash Budget
__________Co. Ltd.
Cash Budget
Period______________

Month 1 Month 2 Month 3 Month 12

Receipts:
1. Opening balance
2. Collection from
debtors

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 10.40 FINANCIAL MANAGEMENT

3. Cash sales
4. Loans from banks
5. Share capital
6. Miscellaneous
receipts
7. Other items
Total
Payments:
1. Payments to creditors
2. Wages
3. Overheads
(a)
(b)
(c)
4. Interest
5. Dividend
6. Corporate tax
7. Capital expenditure
8. Other items
Total
Closing balance
[Surplus (+)/Shortfall (-)]
Students are required to do good practice in preparing the cash budgets. The
following illustration will show how short-term cash budgets can be prepared.
ILLUSTRATION 6
PREPARE monthly cash budget for six months beginning from April 2021 on the basis
of the following information:
(i) Estimated monthly sales are as follows:
` `
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000

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 MANAGEMENT OF WORKING CAPITAL 10.41

March 1,40,000 August 80,000

April 80,000 September 60,000
May 60,000 October 1,00,000

(ii) Wages and salaries are estimated to be payable as follows:-

` `
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are
collected within one month after sale and the balance in two months after sale.
There are no bad debt losses.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the
month preceding the sales.
(v) The firm has 10% debentures of ` 1,20,000. Interest on these has to be paid
quarterly in January, April and so on.
(vi) The firm is to make an advance payment of tax of ` 5,000 in July, 2021.
(vii) The firm had a cash balance of ` 20,000 on April 1, 2021, which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level
is made up by temporary investments/liquidation of temporary investments or
temporary borrowings at the end of each month (interest on these to be
ignored).
SOLUTION
Workings:
Collection from debtors:
(Amount in `)
February March April May June July August September

Total sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000

Credit sales
(80% of
total sales) 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000

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 10.42 FINANCIAL MANAGEMENT

Collections:

One month 72,000 84,000 48,000 36,000 48,000 60,000 48,000

Two 24,000 28,000 16,000 12,000 16,000 20,000

months

Total
collections 1,08,000 76,000 52,000 60,000 76,000 68,000

Monthly Cash Budget for Six months, April to September, 2021

(Amount in `)

April May June July August September

Receipts:
Opening balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collection from 1,08,000 76,000 52,000 60,000 76,000 68,000
debtors
Total cash available (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages & salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 --- --- 3,000 --- ---
Tax payment --- --- --- 5,000 --- ---
Total payments (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum cash balance
desired 20,000 20,000 20,000 20,000 20,000 20,000
Total cash needed (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus - deficit (A-C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investment/financing
Temporary (64,000) (16,000) ---- (35,000) -----
Investments
Liquidation of
temporary investments
or temporary ---- ---- 22,000 2,000 ---- 9,000
borrowings

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 MANAGEMENT OF WORKING CAPITAL 10.43

Total effect of
investment/financing (64,000) (16,000) 22,000 2,000 (35,000) 9,000
(D)
Closing cash balance
(A+D-B) 20,000 20,000 20,000 20,000 20,000 20,000

ILLUSTRATION 7
From the following information relating to a departmental store, you are required to
PREPARE for the three months ending 31st March, 2021:
(a) Month-wise cash budget on receipts and payments basis; and
(b) Statement of Sources and uses of funds for the three months period.
It is anticipated that the working capital & other account balances at 1st January,
2021 will be as follows:

` in ‘000
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
Budgeted Profit Statement: ` in ‘000
January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, Selling and
Distribution Expenses 315 270 255
Net Profit before tax 150 125 115

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 10.44 FINANCIAL MANAGEMENT

Budgeted ` in ‘000
balances at
the end of
each months
31st Jan. 28th Feb. 31st March
Short term 700 --- 200
investments
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade 2,000 1,950 1,900
creditors
Other 200 200 200
creditors
Dividends 485 -- --
payable
Tax due 320 320 320
Plant 800 1,600 1,550
(depreciation
ignored)

Depreciation amount to ` 60,000 is included in the budgeted expenditure for each

month.
SOLUTION
Workings:

` in ‘000
Jan. Feb. March
(1) Payments to creditors:
Cost of Sales 1,635 1,405 1,330
Add: Closing Stocks 1,200 1,100 1,000
2,835 2,505 2,330
Less: Opening Stocks 1,300 1,200 1,100
Purchases 1,535 1,305 1,230

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 MANAGEMENT OF WORKING CAPITAL 10.45

Add: Trade Creditors, Opening balance 2,110 2,000 1,950

3,645 3,305 3,180
Less: Trade Creditors, closing balance 2,000 1,950 1,900
Payment 1,645 1,355 1,280
(2) Receipts from debtors:
Debtors, Opening balances 2,570 2,600 2,500
Add: Sales 2,100 1,800 1,700
4,670 4,400 4,200
Less: Debtors, closing balance 2,600 2,500 2,350
Receipt 2,070 1,900 1,850

CASH BUDGET
(a) 3 months ending 31st March, 2021

(` in 000)
January, February, March,
2021 2021 2021
Opening cash balances 545 315 65
Add: Receipts:
From Debtors 2,070 1,900 1,850
Sale of Investments --- 700 ----
Sale of Plant --- --- 50
Total (A) 2,615 2,915 1,965
Deduct: Payments
Creditors 1,645 1,355 1,280
Expenses 255 210 195
Capital Expenditure --- 800 ---
Payment of dividend --- 485 ---
Purchase of investments 400 --- 200
Total payments (B) 2,300 2,850 1,675
Closing cash balance (A-B) 315 65 290

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 10.46 FINANCIAL MANAGEMENT

(b) Statement of Sources and uses of Funds for the three month period
ending 31st March, 2021
` ’000 ` ’000
Sources:
Funds from operation:
Net profit (150+125+115) 390
Add: Depreciation (60×3) 180 570
Sale of plant 50
620
Decrease in Working Capital 665
(Refer Statement of changes in working capital)
Total 1,285
Uses:
Purchase of plant 800
Payment by dividends 485
Total 1,285
Statement of Changes in Working Capital

January,21 March,21 Increase Decrease

`’ 000 `’ 000 `’ 000 `’ 000
Current Assets
Cash in hand and at Bank 545 290 255
Short term Investments 300 200 100
Debtors 2,570 2,350 220
Stock 1,300 1,000 300
4,715 3,840
Current Liabilities
Trade Creditors 2,110 1,900 210 ---
Other Creditors 200 200 --- ---
Tax Due 320 320 --- ---
2,630 2,420
Working Capital 2,085 1,420
Decrease - 665 665
2,085 2,085 875 875

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 MANAGEMENT OF WORKING CAPITAL 10.47

10.10.2 Cash Budget for long period

Long-range cash forecast often resemble the projected sources and application of
funds statement. The following procedure may be adopted to prepare long-range
cash forecasts:
(i) Take the cash at bank and in the beginning of the year
(ii) Add:
(a) Trading profit (before tax) expected to be earned;
(b) Depreciation and other development expenses incurred to be written
off;
(c) Sale proceeds of assets;
(d) Proceeds of fresh issue of shares or debentures; and
(e) Reduction in working capital that is current assets (except cash) less
current liabilities.
(iii) Deduct:
(a) Dividends to be paid.
(b) Cost of assets to be purchased.
(c) Taxes to be paid.
(d) Debentures or preference shares to be redeemed.
(e) Increase in working capital that is current assets (except cash) less
current liabilities.
ILLUSTRATION 8
You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
` ` ` `
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses

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 10.48 FINANCIAL MANAGEMENT

To Other Expenses 1,00,00,000 1,00,00,000

To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000 - -
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000

Sales are expected to be ` 12,00,00,000 in year 3.

As a result, other expenses will increase by ` 50,00,000 besides other charges. Only
raw materials are in stock. Assume sales and purchases are in cash terms and the
closing stock is expected to go up by the same amount as between year 1 and 2. You
may assume that no dividend is being paid. The Company can use 75% of the cash
generated to service a loan. COMPUTE how much cash from operations will be
available in year 3 for the purpose? Ignore income tax.
SOLUTION
Projected Profit and Loss Account for the year 3

Year 2 Year 3 Year 2 Year 3

Actual Projected Actual Projected
(` in (` in (` in (` in
lakhs) lakhs) lakhs) lakhs)
To Materials 350 420 By Sales 1,000 1,200
consumed
To Stores 120 144 By Misc. 10 10
Income
To Mfg. Expenses 160 192
To Other expenses 100 150
To Depreciation 100 100
To Net profit 180 204
1,010 1,210 1,010 1,210
Cash Flow:

(` in lakhs)
Profit 204
Add: Depreciation 100

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 MANAGEMENT OF WORKING CAPITAL 10.49

304
Less: Cash required for increase in stock 50
Net cash inflow 254

Available for servicing the loan: 75% of ` 2,54,00,000 or ` 1,90,50,000

Working Notes:
(i) Material consumed in year 2: 35% of sales.
35
Likely consumption in year 3: `1,200 × or ` 420 (lakhs)
100
(ii) Stores are 12% of sales, as in year 2.
(iii) Manufacturing expenses are 16% of sales.
Note: The above also shows how a projected profit and loss account is prepared.
10.10.3 Managing Cash Collection and Disbursements
Having prepared the cash budget, the finance manager should ensure that there is
not a significant deviation between projected cash flows and actual cash flows.
To achieve this cash management, efficiency will have to be brought in by proper
control of cash collection and disbursement.
The twin objectives in managing the cash flows should be:-
 Accelerate cash collections as much as possible; and
 Decelerate or delay cash disbursements within permissible time frame.
Let’s discuss each of the two objectives individually.
10.10.4 Accelerating Cash Collections
Different Kinds of Float with reference to Management of Cash: First, let’s
understand the time involved in the cash collection process. The term float is used
to refer to the periods that affect cash as it moves through the different stages of
the collection process. Four kinds of float with reference to management of cash
are:
 Billing float: An invoice is the formal document that a seller prepares and sends
to the purchaser as the payment request for goods sold or services provided.
The time between the sale and the mailing of the invoice is known as billing float.

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 10.50 FINANCIAL MANAGEMENT

 Mail float: This is the time when a cheque is being carried by post office,
messenger service or other means of delivery.
 Cheque processing float: This is the time required for the seller to sort,
record and deposit the cheque after it has been received by the company.
 Banking processing float: This is the time from the deposit of the cheque
to the crediting of funds in the sellers’ account.
There are multiple ways in which a firm can attempt to reduce or eliminate any or
all types of floats above. For instance:
♦ A firm can conserve cash and reduce its requirements for cash balances if it
can speed up its cash collections by issuing invoices quickly (reducing /
eliminating billing float);
♦ By reducing the time lag between a customer pays bill and the cheque is
collected (reducing / eliminating mail float);
♦ Making funds become available for the firm’s use (reducing / eliminating
processing floats).
A firm can also use decentralized collection system known as concentration
banking and lock box system to speed up cash collection and reduce float time.
(i) Concentration Banking: In concentration banking, the company establishes
a number of strategic collection centers in different regions instead of a single
collection center at the head office. This system reduces the period between
the time a customer mails in his remittances and the time when they become
spendable funds with the company. Payments received by the different
collection centers are deposited with their respective local banks which in
turn transfer all surplus funds to the concentration bank of head office. The
concentration bank with which the company has its major bank account is
generally located at the headquarters. Concentration banking is one
important and popular way of reducing the size of the float.
(ii) Lock Box System: Another means to accelerate the flow of funds is a lock
box system. While concentration banking, remittances are received by a
collection center and deposited in the bank after processing. The purpose of
lock box system is to eliminate the time between the receipts of remittances
by the company and deposited in the bank. A lock box arrangement usually
is on regional basis which a company chooses according to its billing patterns.

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Under this arrangement, the company rents the local post-office box and
authorizes its bank at each of the locations to pick up remittances in the boxes.
Customers are billed with instructions to mail their remittances to the lock boxes.
The bank picks up the mail several times a day and deposits the cheques in the
company’s account. The cheques may be micro-filmed for record purposes and
cleared for collection. The company receives a deposit slip and lists all payments
together with any other material in the envelope. This procedure frees the
company from handling and depositing the cheques.
The main advantage of lock box system is that cheques are deposited with the
banks sooner and become collected funds sooner than if they were processed by
the company prior to deposit. In other words, lag between the time cheques are
received by the company and the time they are actually deposited in the bank (i.e.
cheque processing float) is eliminated.
The main drawback of lock box system is the cost of its operation. The bank
provides a number of services in addition to usual clearing of cheques and requires
compensation for them. Since the cost is almost directly proportional to the
number of cheques deposited. Lock box arrangements are usually not profitable if
the average remittance is small. The appropriate rule for deciding whether or not
to use a lock box system or for that matter, concentration banking, is simply to
compare the added cost of the most efficient system with the marginal income that
can be generated from the released funds. If costs are less than income, the system
is profitable and if the system is not profitable, it is not worth undertaking.
10.10.5 Controlling Payments
An effective control over payments can also cause faster turnover of cash. This is
possible only by making payments on the due date, making excessive use of draft
(bill of exchange) instead of cheques.
Availability of cash can be maximized by playing the float. In this, a firm estimates
accurately the time when the cheques issued will be presented for encashment and
thus utilizes the float period to its advantage by issuing more cheques but having
in the bank account only so much cash balance as will be sufficient to honour those
cheques which are actually expected to be presented on a particular date.
Also, the company may make payment to its outstation suppliers by a cheque and
send it through mail. The delay in transit and collection of the cheque, will be used
to increase the float.

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ILLUSTRATION 9
Prachi Ltd is a manufacturing company producing and selling a range of cleaning
products to wholesale customers. It has three suppliers and two customers. Prachi Ltd
relies on its cleared funds forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare
a cleared funds forecast for the period Saturday 7 August to Wednesday 11 August
2021 inclusive. You have been provided with the following information:
(1) Receipts from customers

Credit terms Payment 7 Aug 7 Jul 2021

method 2021 sales sales
W Ltd 1 calendar month BACS ` 150,000 ` 130,000
X Ltd None Cheque ` 180,000 ` 160,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is
instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same
day as the sale is made and will clear on the third day following this
(excluding day of payment).
(2) Payments to suppliers

Supplier Credit Payment 7 Aug 7 Jul 7 Jun

name terms method 2021 2021 2021
purchases purchases purchases
A Ltd 1 calendar Standing ` 65,000 ` 55,000 ` 45,000
month order
B Ltd 2 calendar Cheque ` 85,000 ` 80,000 ` 75,000
months
C Ltd None Cheque ` 95,000 ` 90,000 ` 85,000
(a) Prachi Ltd has set up a standing order for ` 45,000 a month to pay for
supplies from A Ltd. This will leave Prachi’s bank account on 7 August.
Every few months, an adjustment is made to reflect the actual cost of
supplies purchased (you do NOT need to make this adjustment).

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 MANAGEMENT OF WORKING CAPITAL 10.53

(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August.
The amounts will leave its bank account on the second day following this
(excluding the day of posting).
(3) Wages and salaries
July 2021 August 2021
Weekly wages ` 12,000 ` 13,000
Monthly salaries ` 56,000 ` 59,000
(a) Factory workers are paid cash wages (weekly). They will be paid one
week’s wages, on 11 August, for the last week’s work done in July (i.e.
they work a week in hand).
(b) All the office workers are paid salaries (monthly) by BACS. Salaries for
July will be paid on 7 August.
(4) Other miscellaneous payments
(a) Every Saturday morning, the petty cashier withdraws ` 200 from the
company bank account for the petty cash. The money leaves Prachi’s
bank account straight away.
(b) The room cleaner is paid ` 30 from petty cash every Monday morning.
(c) Office stationery will be ordered by telephone on Sunday 8 August to the
value of ` 300. This is paid for by company debit card. Such payments are
generally seen to leave the company account on the next working day.
(d) Five new softwares will be ordered over the Internet on 10 August at a
total cost of ` 6,500. A cheque will be sent out on the same day. The
amount will leave Prachi Ltd’s bank account on the second day following
this (excluding the day of posting).
(5) Other information
The balance on Prachi’s bank account will be ` 200,000 on 7 August 2021. This
represents both the book balance and the cleared funds.
PREPARE a cleared funds forecast for the period Saturday 7th August to
Wednesday 11th August 2021 inclusive using the information provided. Show
clearly the uncleared funds float each day.

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 10.54 FINANCIAL MANAGEMENT

SOLUTION
Cleared Funds Forecast
7 Aug 21 8 Aug 21 9 Aug 21 10 Aug 21 11 Aug 21
(Saturday) (Sunday) (Monday) (Tuesday) (Wednesday)
` ` ` ` `
Receipts
W Ltd 1,30,000 0 0 0 0
X Ltd 0 0 0 1,80,000 0
(a) 1,30,000 0 0 1,80,000 0

Payments

A Ltd 45,000 0 0 0 0

B Ltd 0 0 75,000 0 0

C Ltd 0 0 95,000 0 0

Wages 0 0 0 0 12,000

Salaries 56,000 0 0 0 0

Petty Cash 200 0 0 0 0

Stationery 0 0 300 0 0

(b) 1,01,200 0 1,70,300 0 12,000

Cleared excess Receipts

over payments (a) – (b) 28,800 0 (1,70,300) 1,80,000 (12,000)

Cleared balance b/f 2,00,000 2,28,800 2,28,800 58,500 2,38,500

Cleared balance c/f (c) 2,28,800 2,28,800 58,500 2,38,500 2,26,500

Uncleared funds float

Receipts 1,80,000 1,80,000 1,80,000 0 0

Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)

(d) 10,000 9,700 180,000 (6,500) (6,500)

Total book balance c/f 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000

(c)+ (d)

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 MANAGEMENT OF WORKING CAPITAL 10.55

10.10.6 Determining the Optimum Cash Balance

A firm should maintain optimum cash balance to cater to the day-to-day
operations. It may 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 an optimum level i.e. just enough, i.e. neither too much (to avoid any
opportunity cost) nor too little cash balance (to settle day to day payments). This,
however, poses a question. How to determine the optimum cash balance if cash
flows are predictable and if they are not predictable?

10.11 CASH MANAGEMENT MODELS

In recent years several types of mathematical models have been developed which
helps to determine the optimum cash balance to be carried by a business
organization.
The purpose of all these models is to ensure that cash does not remain idle
unnecessarily and at the same time the firm is not confronted with a situation of
cash shortage.
All these models can be put in two categories:
Inventory type models; and Stochastic models.
Inventory type models have been constructed to aid the finance manager to
determine optimum cash balance of his firm. William J. Baumol’s economic order
quantity model applies equally to cash management problems under conditions of
certainty or where the cash flows are predictable.
However, in a situation where the EOQ Model is not applicable, stochastic model
of cash management helps in determining the optimum level of cash balance. It
happens when the demand for cash is stochastic and not known in advance.
10.11.1 William J. Baumol’s Economic Order Quantity Model, (1952)
According to this model, optimum cash level is that level of cash where the
carrying costs and transactions costs are the minimum.
The carrying costs refer to the cost of holding cash, namely, the opportunity cost
or interest foregone on marketable securities. The transaction costs refer to the
cost involved in getting the marketable securities converted into cash. This
happens when the firm falls short of cash and has to sell the securities resulting in
clerical, brokerage, registration and other costs.

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 10.56 FINANCIAL MANAGEMENT

The optimum cash balance according to this model will be that point where these
two costs are minimum. The formula for determining optimum cash balance is:

2U×P
C=
S

Where, C = Optimum cash balance

U = Annual (or monthly) cash disbursement

P = Fixed cost per transaction.

S = Opportunity cost of one rupee p.a. (or p.m.)
This can be explained with the following diagram:

The model is based on the following assumptions:

(i) Cash needs of the firm are known with certainty.
(ii) The cash is used uniformly over a period of time and it is also known with
certainty.
(iii) The holding cost is known and it is constant.
(iv) The transaction cost also remains constant.
ILLUSTRATION 10
A firm maintains a separate account for cash disbursement. Total disbursement are
` 1,05,000 per month or ` 12,60,000 per year. Administrative and transaction cost

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 MANAGEMENT OF WORKING CAPITAL 10.57

of transferring cash to disbursement account is ` 20 per transfer. Marketable

securities yield is 8% per annum.
DETERMINE the optimum cash balance according to William J. Baumol model.
SOLUTION

2×`12,60,000×` 20
The optimum cash balance C = =` 25,100
0.08

The limitation of the Baumol’s model is 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 outflows. The Miller-Orr (MO) model, as
discussed below, overcomes this shortcoming and allows for daily cash flow
variation.
10.11.2 Miller-Orr Cash Management Model (1966)
According to this model the net cash flow is completely stochastic.
When changes in cash balance occur randomly the application of control theory
serves a useful purpose. The Miller-Orr model is one of such control limit models.
This model is designed to determine the time and size of transfers between an
investment account and cash account. In this model control limits are set for cash
balances. These limits may consist of h as upper limit, z as the return point; and
zero as the lower limit.
 When the cash balance reaches the upper limit, the transfer of cash equal to
h – z is invested in marketable securities account.
 When it touches the lower limit, a transfer from marketable securities account
to cash account is made.

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 10.58 FINANCIAL MANAGEMENT

 During the period when cash balance stays between (h, z) and (z, 0) i.e. high
and low limits no transactions between cash and marketable securities
account is made.
The high and low limits of cash balance are set up on the basis of fixed cost
associated with the securities transactions, the opportunity cost of holding cash
and the degree of likely fluctuations in cash balances. These limits satisfy the
demands for cash at the lowest possible total costs. The following diagram
illustrates the Miller-Orr model.

The MO Model is more realistic since it allows variations in cash balance within
lower and upper limits. The finance manager can set the limits according to the
firm’s liquidity requirements i.e., maintaining minimum and maximum cash balance.

10.12 RECENT DEVELOPMENTS IN CASH

MANAGEMENT
It is important to understand the latest developments in the field of cash
management, since it has a great impact on how we manage our cash. Both
technological advancement and desire to reduce cost of operations has led to some
innovative techniques in managing cash. Some of them are:-

Electronic Money Petty Cash

Zero Balance
Fund Market Imprest
Account
Transfer Operations System

Electronic
Management
Cash Virtual
of Temporary
Management Banking
Cash Surplus
System

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 MANAGEMENT OF WORKING CAPITAL 10.59

10.12.1 Electronic Fund Transfer

With the developments which took place in the Information technology, the
present banking system is switching over to the computerisation of banks branches
to offer efficient banking services and cash management services to their
customers. The network will be linked to the different branches, banks. This will
help the customers in the following ways:
 Instant updating of accounts.
 Quick transfer of funds.
 Instant information about foreign exchange rates.
10.12.2 Zero Balance Account
For efficient cash management some firms employ an extensive policy of
substituting marketable securities for cash by the use of zero balance accounts.
Every day the firm totals the cheques presented for payment against the account.
The firm transfers the balance amount of cash (in excess of payments) in the
account if any, for buying marketable securities. In case of shortage of cash, the
firm sells the marketable securities.
10.12.3 Money Market Operations
One of the tasks of ‘treasury function’ of larger companies is the investment of
surplus funds in the money market. The chief characteristic of money market
banking is one of size. Banks obtain funds by competing in the money market for
the deposits by the companies, public authorities, High Net worth Investors (HNI),
and other banks. Deposits are made for specific periods ranging from overnight to
one year; highly competitive rates which reflect supply and demand on a daily, even
hourly basis are quoted. Consequently, the rates can fluctuate quite dramatically,
especially for the shorter-term deposits. Surplus funds can thus be invested in
money market easily.
10.12.4 Petty Cash Imprest System
For better control on cash, generally the companies use petty cash imprest system
wherein the day-to-day petty expenses are estimated taking into account past
experience and future needs and generally a week’s requirement of cash will be
kept separate for making petty expenses. Again, the next week will commence with
the pre-determined balance. This will reduce the strain of the management in
managing petty cash expenses and help in the managing cash efficiently.

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 10.60 FINANCIAL MANAGEMENT

10.12.5 Management of Temporary Cash Surplus

Temporary cash surpluses can be profitably invested in the following:
 Short-term deposits in Banks and financial institutions.
 Short-term debt market instruments.
 Long-term debt instruments.
 Shares of Blue chip listed companies.
Choice of investment can be based on economic situation, volatility of returns
and also the risk appetite of the organization.
10.12.6 Electronic Cash Management System
Most of the cash management systems now-a-days are electronically based, since
‘speed’ is the essence of any cash management system. Electronically, transfer of
data as well as funds play a key role in any cash management system. Various
elements in the process of cash management are linked through a satellite. Various
places that are interlinked may be the place where the instrument is collected, the
place where cash is to be transferred in company’s account, the place where the
payment is to be transferred etc.
Certain networked cash management system may also provide a very limited access
to third parties like parties having very regular dealings of receipts and payments
with the company etc. A finance company accepting deposits from public through
sub-brokers may give a limited access to sub-brokers to verify the collections made
through him for determination of his commission among other things.
Electronic-scientific cash management results in:
 Significant saving in time.
 Increase in interest earned & decrease in interest expense.
 Reduces paper-work & hence manpower.
 Greater accounting accuracy as it allows easy detection of book-keeping errors.
 More control over time and funds.
 Supports electronic payments.
 Faster transfer of funds from one location to another, where required.
 Speedy conversion of various instruments into cash.
 Making available funds wherever required, whenever required.

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 MANAGEMENT OF WORKING CAPITAL 10.61

 Reduction in the amount of ‘idle float’ to the maximum possible extent.

 Ensures no idle funds are placed at any place in the organization.
 It makes inter-bank balancing of funds much easier.
 It is a true form of centralized ‘Cash Management’.
 Produces faster electronic reconciliation.
 Reduces the number of cheques issued.
10.12.7 Virtual Banking
The practice of banking has undergone a significant change in the nineties. While
banks are striving to strengthen customer base and relationship and move towards
relationship banking, customers are increasingly moving away from the confines of
traditional branch banking and are seeking the convenience of remote electronic
banking services. And even within the broad spectrum of electronic banking the
virtual banking has gained prominence
Broadly virtual banking denotes the provision of banking and related services
through extensive use of information technology without direct recourse to the
bank by the customer. The origin of virtual banking in the developed countries can
be traced back to the seventies with the installation of Automated Teller Machines
(ATMs). Subsequently, driven by the competitive market environment as well as
various technological and customer pressures, other types of virtual banking
services have grown in prominence throughout the world.
The Reserve Bank of India has been taking a number of initiatives, which will facilitate
the active involvement of commercial banks in the sophisticated cash management
system. One of the pre-requisites to ensure faster and reliable mobility of funds in a
country is to have an efficient payment system. Considering the importance of speed
in payment system to the economy, the RBI has taken numerous measures since mid-
Eighties to strengthen the payments mechanism in the country.
Introduction of computerized settlement of clearing transactions, use of Magnetic
Ink Character Recognition (MICR) technology, provision of inter-city clearing
facilities and high value clearing facilities, Electronic Clearing Service Scheme
(ECSS), Electronic Funds Transfer (EFT) scheme, Real Time Gross Settlement System
(RTGS), Delivery vs. Payment (DVP) for Government securities transactions, setting
up of Indian Financial Network (INFINET) are some of the significant developments.
Other than above, Introduction of Centralised Funds Management System (CFMS),
Securities Services System (SSS) and Structured Financial Messaging System (SFMS)

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have been the other top priority items on the agenda to transform the existing
system into a state-of-the art payment infrastructure in India.
The current vision envisaged for the payment systems reforms is one, which
contemplates linking up of all the remaining bank branches with the domestic
payment systems network thereby facilitating cross border connectivity. With the
help of the systems already put in place in India and which are coming into being,
both banks and corporates can exercise effective control over the cash
management.
Advantages of Virtual Banking
The advantages of virtual banking services are as follows:
 Lower cost of handling a transaction.
 The increased speed of response to customer requirements.
 The lower cost of operating branch network along with reduced staff costs
leads to cost efficiency.
 Virtual banking allows the possibility of improved and a range of services
being made available to the customer rapidly, accurately and at his
convenience.
The popularity which virtual banking services have won among customers is due to
the speed, convenience and round the clock access they offer.

10.13 MANAGEMENT OF MARKETABLE SECURITIES

Management of marketable securities is an integral part of investment of cash as
this may serve both the purposes of liquidity and cash, provided choice of
investment is made correctly. As the working capital needs are fluctuating, it is
possible to park excess funds in some short-term securities, which can be liquidated
when need for cash is felt. The selection of securities should be guided by three
principles.
 Safety: Return and risks go hand in hand. As the objective in this investment
is ensuring liquidity, minimum risk is the criterion of selection.
 Maturity: Matching of maturity and forecasted cash needs is essential. Prices
of long term securities fluctuate more with changes in interest rates and are
therefore, riskier. Since this is for temporary excess funds, short term
securities are preferred.

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 Marketability: It refers to the convenience, speed and cost at which a security

can be converted into cash. If the security can be sold quickly without loss of
time and price it is highly liquid or marketable.
The choice of marketable securities is mainly limited to Government treasury bills,
Deposits with banks and Inter-corporate deposits. Units of Unit Trust of India and
commercial papers of corporates are other attractive means of parking surplus
funds for companies along with deposits with sister concerns or associate
companies.
Besides this Money Market Mutual Funds (MMMFs) have also emerged as one of
the avenues of short-term investment.
ILLUSTRATION 11
The following information is available in respect of Sai trading company:
(i) On an average, debtors are collected after 45 days; inventories have an average
holding period of 75 days and creditor’s payment period on an average is 30 days.
(ii) The firm spends a total of ` 120 lakhs annually at a constant rate.
(iii) It can earn 10 per cent on investments.
From the above information, you are required to CALCULATE:
(a) The cash cycle and cash turnover,
(b) Minimum amounts of cash to be maintained to meet payments as they become due,
(c) Savings by reducing the average inventory holding period by 30 days.
SOLUTION
(a) Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months)
Cash turnover = 12 months (360 days)/3 months (90 days) = 4.
(b) Minimum operating cash = Total operating annual outlay/cash turnover, that
is, ` 120 lakhs/4 = ` 30 lakhs.
(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months).
Cash turnover = 12 months (360 days)/2 months (60 days) = 6.
Minimum operating cash = ` 120 lakhs/6 = ` 20 lakhs.
Reduction in investments = ` 30 lakhs – ` 20 lakhs = ` 10 lakhs.
Savings = 0.10 × ` 10 lakhs = ` 1 lakh.

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