Corporate Financial Management

Chapter-8

CASH MANAGEMENT

Introduction

Cash is one of the most liquid assets. Its efficient management is crucial to solvency of
the business.

Cash is different from profits

A business might be making good profits but might frequently suffer cash shortages. This
can happen if the goods are sold on credit and receivables accumulate without realization.
It can happen if huge advances are paid in anticipation of future supply. It can happen if
profits generated instead of re-using in the business are taken out by way of large
dividends.

On the other hand a losing business might have lots of cash. This can arise with constant
raising of funds by the business by borrowing. A business might default in payment to
creditors and retain cash with it.

Profits of a business arise from cash incomes and non cash incomes (sale on credit,
discounts received etc.). Expenses would include cash expenses and non cash expenses
(depreciation, expenses written off etc.). Outstanding expenses like unpaid salaries, rent
etc. are deducted from income while there is no cash outgo thereof. These will have to
added /subtracted to arrive at the cash generation. The term cash also includes cash in
hand and bank balance. While profits reflect the earning capacity of a company, cash
reflects its liquidity position.

Need for cash

There are three motives for any business to hold cash.

- Transaction Motive

A business enters into various transactions with other entities. The inflows from
transaction and outflows from transaction might not always match. There is need
to keep cash to cushion the imbalances.

- Precautionary motive

This is to meet unforeseen sudden requirements for expenses. Eg: An accident,

employee strike, sudden demand etc. The business has to be prepared to face such
situations.

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- Speculative motive

Cash can also be used for speculation in anticipation of opportunities that do not
arise in the normal course of the business. For instance a firm might want to buy
up material in advance in anticipation of future price rises. A firm might want to
undertake investments which might yield quick short term gains.

Issues in Cash Management

Cash provides liquidity to the business. It gives the comfort to meet unexpected
expenditures. It also satisfies creditors that their financial assets are good. However cash
and bank balances like other current assets if held in excess represents a wasted
opportunity. The cash in physical form is an idle asset and earns no return. Cash in bank
or other liquid or marketable investment, earns low return. As such excess cash results in
opportunity loss. Further to hold liquid cash, funds would have to be raised which cost
money.

Thus cash should be held optimally to provide liquidity as well as profitability.

Tools for cash management

Cash Forecasting and Budget

The time frame chosen for cash budgeting is normally one year. For better monitoring,
budgets are prepared quarterly and sometimes even monthly/fortnightly basis. The cash
budget can be illustrated with an example.

Eg:1- Akbar Industries wants to prepare a cash budget for period of 6 months starting
from January 2003. The relevant details related to working of the company are given
below:

1. The actual sales during November ad December 2002 and forecast of sales for
the first 6 months of 2003 are given below.

Actual Sales Forecast Sales

November 2002 100000 January 100000
December 2002 100000 February 100000
March 120000
April 120000
May 140000
June 140000

2. Cash sales and credit sales are expected to be 20% and 80% respectively.
3. Receivables from credit sales are expected to be collected as follows:
After 1 month - 50%
After 1 month - 50%

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4. Bad debt losses are unlikely.

5. In the month of June 2003, 2000 Riyals are expected from sale of a machine
and another 2000 Riyals by way of interest earned on security.
6. The expected purchases are forecast below. The payment for these purchases
are made a month after the purchase. Payment for December purchases will be
made in January.

Period Actual Period Forecast purchases

purchases
December 2002 40000 January 40000
February 40000
March 45000
April 50000
May 55000
June 55000

7. Miscellaneous cash purchases of 2500 per month are planned from January
through June.
8. Wage payments are expected to be 16000 Riyals per month. Manufacturing
expenses expected to be 20000 Riyals per month. General administrative and
selling expenses are expected to be 10000 Riyals per month.
9. Dividend payment of 20000 Riyals and tax payment of 18000 Riyals are
scheduled in June 2003.
10. A machine worth 55000 Riyals is proposed to be purchased on cash in March-
2003.
11. Opening cash balance is 25000 Riyals. The management policy is to maintain
a minimum cash balance of 18000 Riyals.

Statement of Cash Receipt forecasts

January February March April May June
Cash sales 20000 20000 24000 24000 28000 28000
Credit Sales 80000 80000 80000 88000 96000 104000
Sale of machine 2000
Interest received 2000
Total receipt 100000 100000 106000 112000 124000 134000

Notes:
1. Cash sales = 20%, therefore January it is @20% of Sales = 0.20*100000=20000,
and so on.
2. Credit sales realization will be 50% in the following month of sales and balance
50% two months after sales. Therefore in January, the realization will be
= (0.50* credit sale of Nov 2002+ 0.5* credit sale of December-2002)
3. Credit Sale for any month = 0.80* Sales in that month
4. Credit sale of January-03 = (0.5*0.8*100000+0.5*0.8*100000) = 80000 Riyals.
Similarly for February = 80000 Riyals
5. In March sale of an old machine fetches 2000.

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6. In June receipt of interest from investment amounts to 2000.

Statement of cash payment forecasts

January February March April May June

Purchases on credit 40000 40000 40000 45000 50000 55000
Cash purchase 2500 2500 2500 2500 2500 2500
Wages 16000 16000 16000 16000 16000 16000
Manufacturing 20000 20000 20000 20000 20000 20000
expenses
General 10000 10000 10000 10000 10000 10000
administrative and
selling expenses
Dividend payment 20000
Tax payment 18000
Purchase of 55000
machinery
Total 88500 88500 143500 93500 98500 141500

Cash budget for the period January-June 2003

January February March April May June

Total receipt 100000 100000 106000 112000 124000 134000
Total payments 88500 88500 143500 93500 98500 141500
Net cash flow 11500 11500 -37500 18500 25500 -7500
Opening balance 25000 36500 48000 10500 29000 54500
Closing balance 36500 48000 10500 29000 54500 47000

From the above statement it is observed the cash balances of the company based on
forecast of income and expenses varies from 10500 to 54500 over the period of six
months.

The company for instance might have a policy of keeping a minimum balance of say
20000 and maximum of 40000. In that case the company would have to arrange short
term borrowing to meet the deficit (in relation to 20000) during March and invest surplus
(in relation to 40000) in the months of February and June. This is cash management in
practice.

What happens when liabilities are short term and assets are long term?

Eg: A company raises working capital finance from a bank, which is to be liquidated in a
year. In the normal course the proceeds should be used for buying raw material or
meeting operational expenses. This would have ensured that the cash reconverts into cash
after completion of one operating cycle. However instead of meeting the requirement of
current assets, let us assume that cash is used for buying fixed asset. In such a situation,
money is locked in for a long period. Returns from the fixed asset will arrive only after

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gestation period and a number of periods thereafter. Since lesser money is pumped into
the operations, the scale of activity would reduce and this would lower the profits
resulting in lesser cash generation.

The two effects above (lower cash generation from operations) and cash locked in assets
that will yield returns only over a long term will have an impact on the debt servicing
capability for the business. The debt from the bank will have to be repaid within one year,
whereas cash availability to meet that would have reduced. In such situations businesses
default and face financial embarrassment.

The financial liability will have to be settled within one year though.

If finances are raised to compensate this diversion then there may not be an impact. Still
the business will have to negotiate for further finances for its day-to-day operation. His
might be a cumbersome affair.

Similar problems will confront a business that diverts cash in any other way, which is not
productive. The following table illustrates the effect of diversion.

Beginning Beginning of End of the End of the year

of the year the year year (Actual)
(Estimate) (Actual) (Estimate)
Cash inflow
Loans 100 100
Funds from - - 120 70
operations
Total 100 100 120 70
Cash outflow
Working capital 100 60
Fixed assets 0 40
Repayment - - 100 100
Total outflow 100 100 100 100
Cash 0 0 20 (-) 30
surplus/defici
t

From the above illustration it might be seen that instead of cash surplus of 20 Riyals the
business ends up with a deficit of 30 Riyals. This has resulted due to diverting 40 Riyals
at the beginning of the year into fixed assets.

Monitoring systems

a. Cash Reports: Daily cash reports can be maintained for monitoring the
receivables position. Form of a cash report.

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1. Opening balance -------------

Receipts
2. Cash Sales ----------
3. Collection on credit sales ------------
4. Loans received ------------
5. Other receipts ------------
6. Total Receipts (2+3+4+5) -------------
Payment
7. Cash purchases ----------------
8. Payment to creditors -------------
9. Repayment of loans -------------
10. Other payments ------------------
12 Total payment ---------------- -----------
13. Net cash flow (12-6) ------------
14. Closing balance (1+13) -----------

Factors for efficient cash management

- Prompt billing and mailing

- Collection of Cheque and Remittance of Cash
- Centralized purchases and payments to suppliers.
- Playing the float

The first three above are self-explanatory. There should be no slackness in promptly
billing and mailing reminders for collection. Collection of cheques and bills should be
done without any delay. Suitable arrangements should me made with bankers for transfer
of sums to a central account once the balance exceeds a limit. Many concerns have also
benefited by centralizing both collection and payment to have a tighter control over cash.

The last term “playing the float” needs to be explained a bit. This arises due to the
difference in balances as per books of the company (bank account with the company)
and that of the bank with which it maintains the balances. Float arises on two counts. A
company, which issues a cheque towards payment, immediately debits its books of
account with the amount paid. It is presented for payment and debit in the banks books of
account occurs later. This difference in timing is called payment float.

Similarly, once a company receives a cheque and deposits in the bank account, it credits
its books of account with the cheque amount. However it takes a while before the amount
is actually credited in the bank’s account. This difference in timing is called collection
float.

The difference between the payment float and collection float is called net float. If the net
float is positive the balance in the books of the company is less than that in books of the
bank. In such a case it may issue cheque in excess of balances in its books. This is called
playing the float.

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Practice Exercise

1. Prepare cash budget for Sacremento LLC. with the following information.
a. Purchases for January, February and March are RO 60000 RO 65000 and
RO 70000 respectively. Forty percent is paid in next month and purchase
for December is RO 80000.
b. Rent per month is RO 4000
c. Payment to Directors is RO 6000 per month.
d. RO 35,000 is expected to be outflow towards purchase of a utility vehicle
in the month of March.
e. Revenue is expected to be RO 90000, RO 92000 and RO 90000 in the
three months.
f. Cash expenses are RO 14000 for each month.
g. Present cash balance is RO 15000.

2. The following information regarding Sohar Manufacturing LLC. is available.

a. Sales from July to December are expected to be RO 400,000 per month,
the proportion of cash and credit sales being 2:3. Festive season is
expected to result in additional sales of RO 150,000 in November.
b. Past two months sales have been RO 100,000 each.
c. Credit to collection pattern is 1:1 after one month and two months
respectively.
d. Bad debt losses are 5% of credit sales.
e. Interest on securities is expected to fetch RO 40000 in the month of
August.
f. Estimated purchase is RO 35000 per month on cash basis.
g. RO 5000 is expected to be miscellaneous expenses per month.
h. Manufacturing expenses and wages are expected to be RO 20000 and RO
5000 respectively
i. General, administrative and selling expenses are expected to be RO 5000
per month.
j. Tax and dividend to be paid in the month of December are RO 35000 &
RO 30000 respectively.
k. The company might purchase machinery in October paying RO 540,000.
l. A special market promotion program is proposed in September which is
estimated to cost RO 350,000.
m. The cash balance on July 1, is RO 5000.

Required:
(i) Prepare a cash budget for the period from July to December.
(ii) If the company has a policy of maintaining a minimum balance of RO
100,000 how much money would it require to borrow and when ?
(iii) If the company has a policy of maintaining a maximum cash balance
of RO 500,000 what should be the amount of investment and when
should it be done?

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3. Muscat Bulbs SAOC, has 16 branches all over Sultanate of Oman. Its average
collections per day amounts to RO 600,000. It has a collection arrangement with
a bank wherein the bank branches will collect the money from company’s
branches and transfer the same to company’s main account in Muscat. It takes 5
days for the main account to be credited in this manner. A different bank has
offered to collect and credit the main account in 1 day, provided the company
keeps a minimum deposit of RO 1 million with it. The interest rates at present are
10% per annum.
a. If the new bank does not charge any fee for the collection work should the
firm accept its offer?
b. If instead of the minimum deposit, the new bank asks for an annual fee of
RO 40000 should the firm accept its offer ?

[Answer: (a) should not accept (b) yes it should accept.]

4. A company has total revenue of RO 60 million per year out of which 80% are
credit sales. The collections occur at an even rate and the total working days of
the firm in the year are 300. The Accounts department ties up 4 days worth of
remittance cheques. If the internal delays are removed, this could be reduced by
two days. If the released funds could earn a rate of 9% p.a, what are the annual
savings for the firm?

[Answer : RO 28800]

5. Gulf Cosmetics SAOG, has an excess cash of RO 20 million which can be

invested for a short term. For these transactions the firm incurs an expenditure of
RO 50000. If the securities invested have an annual yield of 8%, what is the
minimum period for the firm to break even its investment expenditure?

[ Answer : 113 days approximately]

6. Nizwa Paper Boards LLC. issues cheques worth RO 15000 and also receives
cheques worth RO 28000 daily. Normally the cheques issued by the company
takes 6 days to be cleared while the bank takes about 3 days for the cheques
deposited by the company to be realized. Assume that the opening credit balance
of the company with the bank is RO 20000. Find out on which date the steady
state condition (constant difference between the company’s books and bank
books) will be reached and calculate the net float?

[Answer: From the end of day 5 . The net positive float would be RO 9000]

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