Pavan K U

GAT, Bangalore

ADVANCED FINANCIAL MANAGEMENT MODULE II

CASH MANAGEMENT 1. CASH MANAGEMENT Management of cash and near cash assets is termed as cash management Cash refers to the ready currency Near cash assets refers to the marketable securities which are highly liquid and viewed in the same way as cash Marketable securities are short term interest earning money market instruments used by the firm to obtain a return on temporary idle funds 2. MOTIVES FOR HOLDING CASH 1. Transaction motive is a motive for holding cash\near cash to meet routine cash requirements to finance transactions in the normal course of business It is to meet anticipated obligations whose timings is not perfectly synchronised with cash receipts Here major portion is held as cash and a part may also be held as marketable securities for obligations whose maturity could be anticipated 2. Precautionary motive is a motive for holding cash\near cash as a cushion to meet unexpected contingencies or demand for cash Firm can maintain a relatively small balance of cash for this purpose, if the firm is able to barrow short tern credit to meet unforeseen obligations and vice versa Such cash balance will held in the form of marketable securities 3. Speculative motive - is a motive for holding cash\near cash to quickly take advantage of opportunities typically outside the normal course of business It is a positive and aggressive approach where the firm aims to exploit profitable opportunities Such cash balance will held in the form of marketable securities 4. Compensating motive is a motive for holding cash\near cash to compensate banks for providing certain services or loans This is the minimum balance to be kept with bank to provide certain services and or giving loans 3. LONG TERM CASH FORECASTING Long term cash can be forecasted through cash cycle and cash turnover Cash cycle is the amount of time cash is tied up between payment for production inputs and receipt of payment from the sale of the resulting finished product Cash cycle = average age of inventory + average collection period average accounts payable 1

Pavan K U Cash turnover is the number of times cash is used during the year

GAT, Bangalore

Number of days in a year Cash turnover = ------------------------------Cash cycle 4. OPTIMAL CASH BALANCE It is the ideal cash balance to be maintained by a firm, which avoids confrontation of cash shortage and idle cash Important models for determining optimum cash balance are Baumals EOQ model Miller-orrs model Stone model 5. BAUMOLS MODEL According to William J Baumol, optimum cash level I s that level of cash where the carrying and transaction costs are the minimum. Carrying cost refers to the cost of holding cash, namely the interest forgone on marketable securities Transaction cost refers to the cost involved in converting marketable securities into cash. It involves clerical, brokerage, registration, and other costs. The formula for determining optimum cash balance is

C= Where, C = optimum cash balance U = Annual (monthly) cash disbursements P = Fixed cost per transaction S = Opportunity cost of one Rupee (or p.m) 6. MILLER-ORR MODEL The Miller-Orr Model provides a formula for determining the optimum cash balance (Z), the point at which to sell securities to raise cash (lower limit L) and when to invest excess cash by buying securities and lowering cash holdings (upper limit H). Depends on: 2

Pavan K U transaction costs of buying or selling securities variability of daily cash (incorporates uncertainty) return on short-term investments MILLER-ORR MODEL

GAT, Bangalore

MILLER-ORR MODEL

RP = Return Point b = Fixed cost per order for converting securities I = Daily interest rate earned 2 = Variance of daily changes in expected cash balance LL = Lower limit or minimum cash balance 7. STONE MODEL The Stone Model is somewhat similar to the Miller-Orr Model insofar as it uses control limits. It incorporates, however, a look-ahead forecast of cash flows when an upper or lower limit is hit to take into account the possibility that the surplus or deficit of cash may naturally correct itself. If the upper control limit is reached, but is to be followed by cash outflow days that would bring the cash balance down to an acceptable level, then nothing is done. If instead the surplus cash would substantially remain that way, then cash is withdrawn to get the cash balance to a predetermined return point. 3

Pavan K U GAT, Bangalore If cash were in short supply and the lower control limit was reached, the opposite would apply. In this way the Stone Model takes into consideration the cash flow forecast. 8. CASH BUDGET Cash budget represents the cash requirements of business during the budget period. It is the plan of receipts and payments of cash during the budget period It can be prepared for short period as well as for long period 9. FORMAT OF CASH BUDGET Particulars Month 1 Month 2 Month 3

Receipts: Opening balance Collection from debtors Cash sales Loan from bank Share capital TOTAL Payments: Payments to creditors Wages Overheads Interest Dividend, tax etc TOTAL Closing balance 10. STRATEGIES FOR MANAGING SURPLUS CASH Selecting Investment opportunities: safety, Maturity, and marketability. Instruments Treasury bills Commercial papers Certificates of deposits Bank deposits Inter-corporate deposits 4

Pavan K U Money market mutual funds 11. STRATEGIES FOR MANAGING SURPLUS CASH According to Keith V Smith Do nothing Make ad hoc investments Ride the yield curve Develop guide lines Utilise control limits Manage with a portfolio perspective Follow a mechanical procedure

GAT, Bangalore