Unit 2

Cash management

Introduction to Cash Management

Management of cash is one of the most important areas of overall
working capital management due to the fact that cash is the most liquid
type of current assets. As such it is the responsibility of the finance
manager to see that the various functional areas of the business have
sufficient cash whenever they require the same.
At the same time, it has also to be ensured that the funds are not blocked
in the form of idle cash, as the cash remaining idle also involves cost in
the form of interest cost and opportunity cost. As such the management
of cash has to find a mean between these two extremes of shortage of
cash as well as idle cash.
Meaning of cash:
Cash is the medium of exchange for purchase of goods and services and
for discharging liabilities.
In cash management, the term has been used in two senses:
(a)Narrow Sense – Under this cash covers currency and generally
accepted equivalents of cash, viz., cheques, demand drafts and
banks demand deposits.
(b) Broad Sense – Here, cash includes not only the above stated
but also near cash assets. They are Bank time deposits and
marketable securities.
Motives for Holding Cash
A company may hold the cash with the various motives as stated below:
 (1) Transaction Motive:
The company may be required to make various regular payments like
purchases, wages/salaries, various expenses, interest, taxes, dividends
etc. for which the company may hold the cash. Similarly, the company
may receive the cash basically from its sales operations.
However, receipts of the cash and the payments by cash may not always
match with each other. In such situations, the company will like to hold
the cash to honour the commitments whenever they become due. This
requirement of cash balances to meet routine needs is known as
transaction motive.
(2) Precautionary Motive:
In addition to the requirement of cash for routine transactions, the
company may also require the cash for such purchases which cannot be
estimated or foreseen. E.g. There may be a sudden decline in the
collection from the customers, there may be a sharp increase in the
prices of the raw materials etc. The company may like to hold the cash
balance to take care of such contingencies and unforeseen
circumstances. This need of cash is known as precautionary motive.
(3) Speculative Motive:
The company may like to hold some reserve kind of cash balance to take
the benefit of favourable market conditions of some specific nature. E.g.
Purchases of raw material available at low prices on the immediate
payment of cash, purchase of securities if interest rates are expected to
increase etc. This need to hold the cash for such purposes is known as
speculative motive.
(4) Compensation Motive : This Motive for holding cash
balances is to compensate banks for providing certain services to
 their clients free of charge. Banks provide variety of services to
business firms, such as clearance of cheque, supply of credit
information, transfer of funds, etc. While for some of the services
bank charges a commission or fee, for others they seek indirect
compensation. In other words, usually clients are required to
maintain a minimum cash balance at the bank, which help them to
earn interest and thus compensate them for the free services so
provided.
Factors determining cash needs:
The factors affecting or determining the cash requirements of a business
are as follows:
1. Nature of product/ business:
The cash requirements of a firm mainly depend on nature of its business.
Trading concerns have to operate large volume of trading activities so
need for cash requirements are very large. On the other hand,
manufacturing or public utility concern need for cash is much less.
Further cash requirement is influenced by firm’s demand.
2. Availability of other sources of fund: Before determining the
cash needs, a company must ascertain the availability of other
sources of fund. In order to meet the emergency obligations, the
financial manager to negotiate short term financing arrangement
with banks or private financial institutions.
3. Attitude of Management:
The attitude of management towards liquidity and profitability affects
the level of cash. If the management attaches more significance to
liquidity than profitability, the level of cash will be high. On the
contrary, if it gives more importance to profitability instead of liquidity,
the level of cash will be low.
4. Efficiency of Management:
If the management can accelerate the collection of cash from customers
and slow down the disbursement of cash, it can keep a low level of cash.
5. Market conditions in relation to assets: Market conditions and
volumes of sales are the important factors to a affect the cash
Requirements. In case of increase in volume of sales and change in
demand for the products and services correspondingly there will be
maintaining huge cash balances to investment in inventories and
account receivables.
6. Operating and cash cycle: Another factor affecting the cash
requirement is the operating and cash cycle. Operating and cache
cycle refers to the length of the period of manufacture which starts
with the procurement of raw material convert into finished goods
and then sells the same. The time that elapses between the
purchase of raw material and the collection of cash for sales is
referred to as the operating cycle whereas the time length between
the payment for raw material purchases and collection of cash for
sales referred to as cash cycle.
7. Consideration of short costs : Cost of short falls in the firm’s
cash needs not only influence the need for working capital but also
increase the cost of production. Such cost incurred as a result of
borrowing cash at high rate of interest, cost associated with legal
formalities, transaction cost incurred with raising cash and loss of
trade discount etc.
Objectives of Cash Management
The prime objective of cash management is to channelize the flow of
cash from the surplus to deficit units to maintain the appropriate
liquidity position of the organization. In addition, the objectives of cash
management can be broadly subdivided into two heads – maintaining the
inflow and outflow of cash and sustaining the cash position held by the
organization to meet the current obligations.
Other important objectives of cash management are discussed as
follows:
i. Planning of Cash Flows – Refers to scheduling the cash inflow
and outflow of an organization over a period of time. The
planning of cash flow helps in maintaining an adequate amount
of capital to finance day-to-day- functions of the organization.
ii. Synchronizing Cash Flows – Refers to developing equilibrium
between inflow and outflow of cash in the business. If the
amount of cash receipts (inflow) is equal to the cash payment
(outflow) then there would be no requirement of holding extra
cash.
iii. Optimizing Cash Holding – Refers to determining the
appropriate amount of cash to be kept in the business to meet
the contingency needs. It is the duty of the finance manager to
decide the optimal cash holding to avoid any excess or deficit of
cash.
iv. Investing Idle Cash – Refers to utilizing the idle cash kept in
the business for short-term investment purposes. An
organization can invest the idle cash in marketable securities for
a short duration to earn a reasonable rate of return. The
marketable securities are highly liquid in nature and can be
easily converted into cash at a short notice.
Cash Budget
Cash budget is an extremely important tool available in the hands of a
finance manager for planning fund requirements and for controlling cash
position in the firm. As a planning device, a cash budget helps the
finance manager to know in advance the cash position of the firm in
different time periods.
The cash budget indicates in which months there will be cash surplus
and in which months the firm will experience cash drain and by how
much.
With the help of this information finance manager can draw up a
programme for financing cash requirements. There will be two
advantages if the finance manager knows in advance as to when
additional funds will be required. First, funds will be available in hand
when needed and there will be no idle funds.
In the absence of the cash budget it may be difficult to determine cash
requirements in different months. If cash required is not available in
time it will land the firm in a difficult position.
Uses of cash budget:
1. Cash budget is used as a tool of cash planning and control.
2. It facilitates co-ordination of total working capital sale, investment
and credit.
3. Cash budget is a pre-determined statement that gives the
estimating cash income and cash expenditure over a some period
of time.
4. It helps to utilise the excess cash in a profitable manner.
5. It ensures adequate or sufficient cash for smooth and effective
operation of the business.
6. It helps to estimate cash requirements of the business during the
budget period.
Importance of Cash Budget:
Cash budget is an important budget for any business concern.
The main advantages of preparing cash budget are as follows:
1. Estimate of Future Position of Cash:
It can be estimated with the help of a cash budget that how much cash
will be needed and when and what will be the position of availability of
cash during the budget period. If there is a position of shortage of cash,
proper arrangement can be made by securing bank overdraft or short-
term borrowings. On the contrary if there is a position of surpluses, a
plan can be made for profitable investment of such funds.
2. Control over Cash Expenditure:
The cash expenses of various departments of an enterprise can easily be
controlled with the help of a cash budget because it reveals the estimated
expenditure of each department. These figures can be compared with
reasonable expenditure and possible cash receipts and necessary
corrective actions may be taken.
3. Formulation of Suitable Dividend Policy:
Cash budget enables the management to formulate a suitable dividend
policy. If the business is not able to obtain sufficient inflow of cash then
the business can restrict its cash dividends.
4. Helpful in Financial Planning:
Cash budget is extremely useful as a tool for financial planning because
it may facilitate coordination between cash on the one hand and working
capital, sales, investments or loan on the other hand.
 5. Regulation of Other Budgets: Cash budget regulates other
budgets such as sales budget, capital budget, etc.
6. Helpful in Fulfillment of Seasonal Needs: This budget is more
helpful in those concerns where there are wide seasonal
fluctuations.
7. Justification of Cash Requirements: The system of preparing a
cash budget helps to convince the bank and other financial
institutions about the bonafides of the cash requirement of the
concern.Thus, it is clear that cash budget is an important tool of
managerial control. In fact, it is like a mirror in which the pattern
of future cash flow is reflected.
Cash Management Models :
• Cash management demands
(i) To have an efficient cash forecasting and reporting systems,
(ii) To achieve optimal conservation and utilisation of funds.
The cash budget tells us the estimated levels of cash balances For the
given period on the basis of expected revenues and Expenditures.
However, if there are shortfalls and surplus, how should these Be
arranged and what should be done with surplus, are the Questions which
are not answered by the cash budget.
For such issues, there are cash management models.
1. Baumol Model
2. Miller and Orr model.
Baumol Model (1952) – EOQ Model
• William J. Baumol proposed a model similar to EOQ for cash
management Too.
• The model helps in determining the cash conversion size which means
how Much cash should be arranged by selling marketable securities in
each Transaction.
• This model assumes that cash can be arranged through selling
marketable Securities which the firms hold in the time of needs.
• There are two types of cost involved in holding cash.
• Opportunity cost
• Transaction cost also known as conversion cost
• The purpose of the model to minimise the total cost of cash holding
which Is summation of opportunity cost and transaction cost.
Assumptions of the model
• The requirement for cash for a given period is known.
• The requirement of cash is distributed evenly throughout the period.
• Selling of securities can be done immediately (There is no delay in
Placing and receiving orders).
• There are two distinguishable costs associated with cash holding:
Opportunity cost and transaction cost.
• The cost per transaction is constant regardless of the size of
Transaction.
• The opportunity is a fixed percentage of the average value of cash
Holding.
The formula for determining optimum cash balance is:
C = √2*U*P/S
Where,
C = optimum cash balance
U = Annual cash disbursement
P = Fixed cost per transaction
S = Opportunity cost of Re. One per annum ( carrying cost )
MILLER-ORR MODEL.
The Miller-Orr Model rectifies some of the deficiencies of the Baumol
Model by accommodating a fluctuating cash flow stream that can be
either inflow or outflow. The Miller-Orr Model has an upper limit U and
lower limit L
When there is too much cash and U is reached, cash is taken out (to buy
short-term securities to earn interest) such that the cash balance goes to
a return (R) point. Otherwise, if there is too little cash and L is reached,
cash is deposited (from the short-term investments) to replenish the
balance to R
What are Marketable Securities?
Marketable Securities are short-term investments with high liquidity that
could be sold and be converted into cash quickly
Marketable securities are highly-liquid financial tools that can be sold or
converted into cash within a year of investment. Businesses issue these
securities to raise capital for operating expenses or business expansion.
On the other hand, a business invests in marketable securities to make
some short-term earnings with the cash at hand.
Purpose of Investing in Marketable Securities
Usually, businesses invest in marketable securities for one of three
reasons. Based on the reason for investment, the way of handling the
funds is determined.
1. Held Until Maturity: Companies hold on to the securities until the
maturity date. If the date is well within a year’s time, the
investment is called short-term investment. If the maturity date
 exceeds a year from the purchase date, they are called long-term
investment and non-current assets.
Their fair value is listed in the company’s balance sheet, and the
temporary fluctuations are ignored. Any realised gains or losses are
listed in the balance sheet.
2. For Trading: The marketable securities are purchased for the sole
purpose of generating a short-term profit and are held for a period
less than a year. Along with listing the fair value of the holdings in
the balance sheet, any gains and losses incurred during the holding
period are also recorded. If there are any temporary fluctuations in
the market, they are recorded in the income statement.
3. For Sale: If the securities are not purchased for trading or to be
held until maturity, they are purchased to sell. They are listed at the
fair value in the balance sheet with unrealised gains or losses.
Unlike in the second case, temporary gains and losses need not be
reported in the income statement.
Types of marketable securities:
There are variety of options available a firm can invest it’s excess
cash used as short term investment. In practice, short term
investments may be in the form of marketable securities. Each
security offers different characteristics that is suitable for different
firm. These securities are:
1. Commercial Paper: Commercial paper refers to a short-term,
unsecured debt obligation that is issued by financial institutions
and large corporations as an alternative to costlier methods of
funding. It is a money market instrument that generally comes
with a maturity of up to 270 days.
Commercial paper is sold at a discount to its face value to
compensate the investor, as opposed to paying cash interest like a
typical debt security. In other words, the difference between the
face value at maturity and the investor’s discounted purchase price
is the investor’s “profit.” The need for commercial paper often
arises due to corporations facing a short-term need to cover
expenses.
Commercial paper is often referred to as an unsecured promissory
note, as the security is not supported by anything other than the
issuer’s promise to repay the face value at the maturity date
specified on the note.
2. Certificate of deposits: The Certificate of Deposit (CD) is an
agreement between the depositor and the bank where a
predetermined amount of money is fixed for a specific time
period Issued by the Federal Deposit Insurance Corporation
(FDIC) and regulated by the Reserve Bank of India, the CD is a
promissory note, the interest on which is paid by the bank The
Certificate of Deposit is issued in dematerialised form i.e. issued
electronically and may automatically be renewed if the
depositor fails to decide what to do with the matured amount
during the grace period of 7 days It also restricts the holder from
withdrawing the amount on demand or paying a penalty,
otherwise. When the Certificate of Deposit matures, the
principal amount along with the interest earned is available for
withdrawal.
3. Bills of exchange or bankers’ acceptance
A bankers’ acceptance is an amount that a borrower borrows, with
a promise to pay in future, backed and guaranteed by the bank
The difference between commercial paper and bills of exchange Is
that bills of exchange, unlike commercial paper, is a secured debt.
Like commercial paper, it is also a short term financial instrument
that is generally used for the purchase of inventory, current assets,
and meeting other short term liabilities.
Bankers’ acceptances specifies the amount of money, the due date,
and the name of the person to whom payment is to be done.
4. Treasury bill: Treasury bills are money market instruments
issued by the Government of India as a promissory note with
guaranteed repayment at a later date. Funds collected through
such tools are typically used to meet short term requirements of
the government, hence, to reduce the overall fiscal deficit of a
country.They are primarily short-term borrowing tools, having a
 maximum tenure of 364 days, available at zero coupons
(interest) rate. They are issued at a discount to the published
nominal value of government security (G-sec).
5. Global Depository Receipts : A global depositary receipt
(GDR) is a negotiable financial instrument issued by a
depositary bank. It represents shares in a foreign company and
trades on the local stock exchanges in investors' countries.
GDRs make it possible for a company (the issuer) to access
investors in capital markets beyond the borders of its own
country. GDRs are commonly used by issuers to raise capital
from international investors through private placement or public
stock offerings.