FinancialManagement

Unit12

Unit12
Structure

CashManagement

12.1 Introduction 12.1.1MeaningofCash 12.2 Meaningandimportanceofcashmanagement 12.3Motivesforholdingcashbalances 12.4 ObjectivesofCashManagement 12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash 12.5.1 12.5.2 12.5.3 12.5.4 BaumolModel MillerOrrmodel CashPlanning CashForecastingandBudgeting

12.6 Summary TerminalQuestions AnswerstoTQsandSAQs.

12.1

Introduction

Cash is the most important current asset for a business operation. It is the energy that drives business activities and also the ultimate output expected by the owners. The firm should keep sufficient cash at all times. Excessive cash will not contribute to the firms profits and shortage of cashwilldisruptitsmanufacturingoperations. 12.1.1 MeaningofCash Thetermcashcanbeusedintwosensesinanarrowsenseitmeansthecurrencyandothercash equivalentssuchascheques,draftsanddemanddepositsinbanks.Inabroadersense,itincludes nearcashassetslikemarketablesecuritiesandtimedepositsinbanks.Thedistinguishingnatureof thiskindofassetisthattheycanbeconvertedintocashveryquickly.Cashinitsownformisanidle asset.Unlessemployedinsomeformoranother,itdoesnotearnanyrevenue.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing.

1. Meaningofcashandnearcashassets 2. Theimportanceofcashmanagementinafirm 3. Thedifferentmodelsofdeterminingtheoptimalcashbalances 4. Techniquesforforecastingthecashinflowsandoutflows.

12.2

MeaningandimportanceofCashManagement

Cashmanagementisconcernedwith(a)managementofcashflowsintoandoutofthefirm,(b)cash managementwithinthefirmand(c)managementofcashbalancesheldbythefirmdeficitfinancing orinvestingsurpluscash.Cashmanagementtriestoaccomplishataminimumcostthevarioustasks ofcashcollection,paymentofoutstandingsandarrangingfordeficitfundingorsurplusinvestment.It is very difficult to predict cash flows accurately. Generally, there is no correlation between inflows and outflows. At some points of time, cash inflows may be lower than outflows because of the seasonal nature of product sale thus prompting the firm to resort to borrowings and sometimes outflows may be lesser than inflows resulting in surplus cash. There is always an element of uncertainty about the inflows and outflows. The firm should therefore evolve strategies to manage cashinthebestpossibleway.Thesecanbebroadlysummarizedas: Cash planning: Cashflows should beappropriatelyplannedtoavoidexcessiveor shortageof cash.Cashbudgetscanbepreparedtoaidthisactivity Managingcashflows:Theflowofcashshouldbeproperlymanaged.Stepstospeedupcash collectionandinflowsshouldbeimplementedwhilecashoutflowsshouldbesloweddown. Optimumcashlevel:Thefirmshoulddecideontheappropriatelevelofcashbalance.Balance shouldbestruckbetweenexcesscashandcashdeficientstage. Investing surplus cash: The surplus cash should be properly invested to earn profits. Many investmentavenuestoinvestsurpluscashareavailableinthemarketsuchas,bankshortterm deposits,TBills,intercorporatelendingetc.

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The ideal cash management system will depend on a number of issues like, firms product, competition,collectionprogram,delayinpayments,availabilityofcashatlowratesofinterestsand investmentopportunitiesavailable.

12.3 MotivesofHoldingCash Therearefourmotivesofholdingcash.Theyare: Transaction motive: This refers to a firm holding cash to meet its routine expenses which are incurredintheordinarycourseofbusiness.Afirmwillneedfinancestomeetaplethoraofpayments likewages,salaries,rent,sellingexpenses,taxes,interests,etc.Thenecessitytoholdcashwillnot arise if there were a perfect coordination between the inflows and outflows. These two never coincide.At times, receipts may exceedoutflows and at other times,paymentsoutrun inflows. For suchperiodswhenpaymentsexceedinflowsthefirmshouldmaintainsufficientbalancestobeable to make the required payments. For transactions motive, a firm may invest its cash in marketable securities. Generally, they purchase such securities whose maturity will coincide with payment obligations. Precautionarymotive:Thisreferstotheneedtoholdcashtomeetsomeexigencieswhichcannot beforeseen.Suchunexpectedneedsmayariseduetosuddenslowdownincollectionofaccounts receivable, cancellation of an order by a customer, sharp increase in prices of raw materials and skilled labour etc. The moneys held to meet such unforeseenfluctuations in cashflowsare called precautionary balances. Theamountof precautionarybalance alsodepends on thefirms abilityto raiseadditionalmoneyatashortnotice.Thegreaterthecreditworthinessofthefirminthemarket, thelesseristheneedforsuchbalances.Generally,suchcashbalancesareinvestedinhighlyliquid andlowriskmarketablesecurities. Speculative motive: This relates to holding cash to take advantage of unexpected changes in businessscenariowhicharenotnormalintheusualcourseoffirmsdealings.Itmayalsoresultin investinginprofitbackedopportunitiesasthefirmcomesacross.Thefirmmayholdcashtobenefit fromafallingpricescenarioorgettingaquantitydiscountwhenpaidincashordelaypurchasesof rawmaterialsinanticipationofdeclineinprices.Byandlarge,businessfirmsdonotholdcashfor speculativepurposesandevenifitisdone,itisdoneonlywithsmallamountsofcash.Speculation maysometimesalsoboomeranginwhichcasethefirmslosealot.

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Compensatingmotive:Thisisyetanothermotivetoholdcashtocompensatebanksforproviding certain services and loans. Banks provide a variety of services like cheque collection, transfer of fundsthroughDD,MT,etc.Toavailallthesepurposes,thecustomersneedtomaintainaminimum balance in their account at all times. The balance so maintained cannot be utilized for any other purpose.Suchbalancesarecalledcompensatingbalances.Compensatingbalancescantakeany ofthefollowingtwoforms(a)maintaininganabsoluteminimum,sayforexample,aminimumofRs. 25000 in current account or (b) maintaining an average minimum balance of Rs. 25000 over the month.Afirmismoreaffectedbythefirstrestrictionthanthesecondrestriction.

12.4 ObjectivesofCashManagement: Therearetwomajorobjectivesforcashmanagementinafirm(a)meetingpaymentsscheduleand (b)minimizingfundsheldintheformofcashbalances. Meeting payments schedule: In the normal course offunctioning, afirm will have to make many payments by cash to its employees, suppliers, infrastructure bills, etc. It will also receive cash throughsalesofitsproductsandcollectionofreceivables.Boththesedonothappensimultaneously. A basic objective of cash management is therefore to meet the payment schedule in time. Timely payments will help the firm to maintain its creditworthiness in the market and to foster good and cordial relationships with creditors and suppliers. Creditors give a cash discount if payments are madeintimeandthefirmcanavailthisdiscountaswell.Tradecreditreferstothecreditextended bythesupplierofgoodsandservicesinthenormalcourseofbusinesstransactions.Generally,cash isnotpaidimmediatelyforpurchasesbutafteranagreedperiodoftime.Thereisdeferralofpayment and is a source of finance. Trade credit does not involve explicit interest charges, but there is an implicitcostinvolved.Ifthecredittermsare,say,2/10,net30,itmeansthecompanywillgetacash discountof2%forpromptpaymentmadewithin10daysorelsetheentirepaymentistobemade within30days.Sincethenetamountisduewithin30days,notavailingdiscountmeanspayingan extra2%for20dayperiod. Theotheradvantageofmeetingthepaymentsintimeisthatitpreventsbankruptcythatarisesoutof thefirms inability to honour its commitments. At the same time, care shouldbetakennot to keep largecashreservesasitinvolveshighcost.

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Minimize funds committed to cash balances: Trying to achieve the second objective is very difficult.Ahighlevelofcashbalanceswillhelpthefirmtomeetitsfirstobjectivediscussedabove,but keepingexcess reserves is also not desirableas funds in its original form is idle cash anda non earningasset.Itisnotprofitableforfirmstokeephugebalances.Alowlevelofcashbalancesmay meanfailuretomeetthepaymentschedule.Theaimofcashmanagementisthereforetohavean optimallevelofcashbybringingaboutapropersynchronizationofinflowsandoutflowsandcheck the spells of cash deficits and cash surpluses. Seasonal industries are classic examples of mismatchesbetweeninflowsandoutflows. The efficiency of cash management can be augmented by controlling a few important factors describedbelow: Promptbillingandmailing:Thereisatimelagbetweenthedispatchofgoodsandpreparationof invoice.Reductionofthisgapwillbringinearlyremittances. Collectionofchequesandremittancesofcash:Itisgenerallyfoundthatthereisadelayinthe receipt of cheques and their deposits into banks. The delay can be reduced by speeding up the processofcollectionanddepositingcashorotherinstrumentsfromcustomers.Theconceptoffloat helpsfirmstoacertainextentincashmanagement.Floatarisesbecauseofthepracticeofbanksnot creditingfirmsaccountinitsbookswhenachequeisdepositedbyitandnotdebitfirmsaccountin its books when a cheque is issued by it until the cheque is cleared and cash is realized or paid respectively. A firm issues and receives cheques on a regular basis. It can take advantage of the concept of float. Whenever cheques are deposited with the bank, credit balance increases in the firmsbooksbutnotinbanksbooksuntilthechequeisclearedandmoneyrealized.Thisrefersto collection float, that is, the amount of cheques deposited into a bank and clearance awaited. Likewise the firm may take benefit of payment float. The difference between payment float and collectionfloatiscalledasnetfloat.Whennetfloatispositive,thebalanceinthefirmsbooksis lessthanthebanksbookswhennetfloatisnegativethefirmsbookbalanceishigherthaninthe banksbooks.

12.5 DeterminingtheCashNeedsModelsforDeterminingOptimalCash One of the prime responsibilities of a Finance Manager is to maintain an appropriate balance between cash and marketable securities. The amount of cash balance will depend on riskreturn
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tradeoff.Afirmwithlesscashbalanceshasaweakliquiditypositionbutmaybeearningprofitsby investingitssurpluscashandontheotherhanditlosesontheprofitsbyholdingtoomuchcash.A balancehastobemaintainedbetweentheseaspectsatalltimes.Sohowmuchisoptimumcash? Thissectionexplainsthemodelsfordeterminingtheappropriatebalance.Twoimportantmodelsare studiedhereBaumolmodelandMillerOrrmodel. 12.5.1 BaumolModel TheBaumolmodelhelpsindeterminingtheminimumcostamountofcashthatamanagercanobtain byconvertingsecuritiesintocash.Itisanapproachtoestablishafirmsoptimumcashbalanceunder certainty.Assuch,firmsattempttominimizethesumofthecostofholdingcashandthecostof convertingmarketablesecuritiestocash.TheBaumolmodelisbasedonthefollowingassumptions: Thefirmisabletoforecastitscashrequirementsinanaccurateway. Thefirmspayoutsareuniformoveraperiodoftime. Theopportunitycostofholdingcashisknownanddoesnotchangewithtime. Thefirmwillincurthesametransactioncostforallconversionsofsecuritiesintocash.

A company will sell securities and realizes cash and this cash is used to make payments. As the cashbalancecomesdownandreachesapoint,theFinanceManagerreplenishesitscashbalance by selling marketable securities available with it and this pattern continues. Cash balances are refilledandbroughtbacktonormallevelsbytheactsofsaleofsecurities.Theaveragecashbalance isC/2.Thefirmbuyssecuritiesasandwhentheyhaveabovenormalcashbalances.Thispatternis explainedbelow:Error! C

Cashbalance

C/2

Average

T1

T2 Time

T3

BaumolsModel

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The total cost associated with cash management has two elements(a) cost of conversion of marketablesecuritiesintocashand(b)theopportunitycost. Thefirm incursa holding costfor keeping cashbalance which is theopportunity cost. Opportunity costisthebenefitforegoneonthenextbestalternativeforthecurrentaction.Holdingcostisk(C/2). Thefirmalsoincursatransactioncostwheneveritconvertsitsmarketablesecuritiesintocash.Total number of transactions during the year will be the total funds requirement, T, divided by the cash balance,C,i.e.T/C.Ifpertransactioncostisc,thenthetotaltransactioncostisc(T/C). Thetotalannualcostofthedemandforcashisk(C/2)+c(T/C).

Error!
Totalcost

Cost

Holdingcost

Transactioncost

Cashbalance

C* BaumolsCutoffModel

TheoptimumcashbalanceC*isobtainedwhenthetotalcostisminimumwhichisexpressedasC*= 2cT/k where C* is the optimum cash balance, c is the cost per transaction, T is the total cash needed during the year and k is the opportunity cost of holding cash balance. The optimum cash balancewillincreasewithincreaseinthepertransactioncostandtotalfundsrequiredanddecrease withtheopportunitycost. Example: AfirmsannualcostrequirementisRs.20000000.Theopportunitycostofcapitalis15%perannum. Rs.150isthepertransactioncostforthefirmwhenitconvertsisshorttermsecuritiestocash.Find

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out the optimum cash balance. What is the annual cost of the demand for the optimum cash balance? Solution C*=2cT/k=[2(150)(20000000)]/0.15=Rs.200000 Theannualcostis150(20000000/200000)+0.15(200000/2)=Rs.30000. Example: MysoreLampsLtd.requiresRs.30lakhstomeetitsquarterlycashrequirements.Theannualreturn on its marketable securities which are of the tune of Rs. 30 lakhs is 20%. The conversion of the securities into cash necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum conversionamount. Solution
@ C*=2cT/k=[2*3000*3000000]/0.05 =Rs.600000

@ is 20% / 4 as 20% is annual return and fund requirement is done on a quarterly basis.

12.5.2

MillerOrrmodel

MillerOrr came out with another model due to the limitation of the Baumol model. Baumol model assumesthatcashflowdoesnotfluctuate.Intherealworld,rarelydowecomeacrossfirmswhich have their cash needs as constant. Keeping other factors such as expansion, modernization, diversification constant, firms face situations wherein they need additional cash to maintain their presentpositionbecauseoftheeffectofinflationarypressures.Thefirmsthereforecannotforecast theirfundrequirementsaccurately.TheMillerOrrmodelovercomesthisshortcomingandconsiders dailycashfluctuations.TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweenan upperbound(uppercontrollimit)andalowerbound(lowercontrollimit).Whencashbalanceshitthe upperlimit,thefirmhastoomuchcashanditistimetobuyenoughmarketablesecuritiestobring backtotheoptimalbound.Whencashbalancestouchzerolevel,thelevelisbroughtupbyselling securitiesintocash.Returnpointliesbetweentheupperandlowerlimits.Symbolically,thiscanbe
2 2 expressedasZ=33/4*(c /i)whereZistheoptimalcashbalance,cisthetransactioncost, is

thestandarddeviationofthenetcashflowsandiistheinterestrate.MOmodelalsosuggeststhe optimumupperboundarybasthreetimestheoptimalcashbalanceandlowerlimit,i.e.upperlimit b=lowerlimit+3Zandreturnpoint=lowerlimit+Z.Thisisshowngraphicallyasfollows:

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Error!
Upperlimit Cashbalance

Returnpoint

MillerOrrModel Example:
Time

Lowerlimit

Mehta industries have a policy of maintaining Rs. 500000 minimum cash balance. The standarddeviationofthe companysdaily cashflows is Rs. 200000. The interest rate is14%. The companyhastospendRs.150pertransaction.Calculatetheupperandlowerlimitsandthereturn pointasperMOmodel. Solution
2 Z=33/4*(c /i) 2 33/4*(150*200000 )/0.14/365=Rs.227226

TheUppercontrollimit=lowerlimit+3Z=500000+3*227226= Rs.1181678 Returnpoint=lowerlimit+Z=500000+227226=Rs.727226 Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 = Rs. 802968 12.5.3CashPlanning Cashplanningisatechniquetoplanandcontroltheuseofcash.Ithelpsindevelopingaprojected cashstatementfromtheexpectedinflowsandoutflowsofcash.Forecastsarebasedonthepast performanceandfutureanticipationofevents.Cashplanningcanbedoneadaily,weeklyorona monthlybasis.Generally,monthlyforecastsarecommonlypreparedbyfirms.

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12.5.4

CashForecastingandBudgeting

Cashbudgetisadevicetoplanforandcontrolcashreceiptsandpayments.Itgivesasummaryof cashflowsoveraperiodoftime.TheFinanceManagercanplanthefuturecashrequirementsofa firmbasedonthecashbudgets.Thefirstelementofacashbudgetistheselectionofthetimeperiod whichisreferredtoastheplanninghorizon.Selectingtheappropriatetimeperiodisbasedonthe factors exclusive to the firms. Some firms may prefer to prepare weekly budget while others may workoutmonthlyestimateswhilesomeothersmaybepreparingquarterlyoryearlybudgets.Firms should keep in mind that the period selected should be neither too long nor too short. Too long a period, estimates will not be accurate and too short a period requires periodic changes. Yearly budgetscanbepreparedbysuchcompanieswhosebusinessisverystableandtheydonotexpect majorchangesaffectingthecompanysflowofcash. The second element that hasabearingon cash budgetpreparation is the selection offactors that have a bearing on cashflows. Only items of cash nature are to be selected while noncash items suchasdepreciationandamortizationareexcluded. Cashbudgetsarepreparedunderthreemethods: 1. ReceiptsandPaymentsmethod 2. IncomeandExpendituremethod 3. BalanceSheetmethod Weshallbediscussingonlythereceiptsandpaymentsmethodofpreparingcashbudgets. Example: GivenbelowisthepreparedacashbudgetofM/s.PandurangaSheetMetalsLtd.forthe6months
th st ending30 June2007.Ithasanopeningcashbalanceof Rs.60000on1 Jan2007.

Month Jan Feb March April May June

Sales Purchases Wages Production overheads 60000 70000 82000 85000 96000 110000 24000 27000 32000 35000 38800 41600 10000 11000 10000 10500 11000 12500 6000 6300 6400 6600 6400 6500

Selling overheads 5000 5500 6200 6500 7200 7500

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The company has a policy of selling its goods 50% on cash basis and the rest on credit terms. Debtorsaregivenamonthstimeperiodtopaytheirdues.Purchasesaretobepaidofftwomonths fromthedateofpurchase.Thecompanyhasatimelaginthepaymentofwagesofamonthand theoverheadsarepaidafteramonth.Thecompanyisalsoplanningtoinvestinamachinewhichwill beusefulforpackingpurposes,thecostbeingRs.45000,payablein3equalinstallments startingbimonthlyfromApril.ItalsoexpectstomakealoanapplicationtoabankforRs.50000and theloanwillbegrantedinthemonthofJuly.ThecompanyhastopayadvanceincometaxofRs. 20000inthemonthofApril.Salesmenareeligibleforacommissionof4%ontotalsaleseffectedby themandthisispayableonemonthafterthedateofsale. Solution Jan Openingcash balance Cashreceipts: Cashsales Creditsales Totalcash available Cash payments Materials Wages Production overheads Selling overheads Sales commission Purchase asset Payment advanceIT of of 5000 23900 5000 10500 6000 5000 2400 24000 10500 6300 5500 2800 27000 10250 6400 6200 3280 15000 20000 49100 117650 59250 79190 32000 10750 6600 6500 3400 35000 11750 6400 7200 3840 15000 30000 35000 30000 41000 35000 42500 41000 48000 42500 55000 48000 60000 Feb March April May June

85000 126100 153000 118850 150100

90000 150000 202100 236500 209350 253100

Total cash payments

Closing cash 85000 126100 153000 118850 150100 173930 balances

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Workingnote: Wagescalculation Jan 10000 5000 5000 Feb 11000 5500feb 5000mar 10500 Mar 10000 5000mar 5500feb 10500 Apr 10500 5250apr 5000mar 10250 May 11000 5500may 5250apr 10750 Jun 12500 6250jun 5500may 11750

SelfAssessmentQuestions1 1. Managementofcashbalancescanbedoneby____________and_________. 2. The four motives for holding cash are ___________, _______________, ____________ and ____________. 3. The greater the creditworthiness of the firm in the market lesser is the need for ___________ balances. 4. __________refers to the credit extended by the supplier of goods and services in the normal courseofbusinesstransactions. 5. When cheques are deposited ina bank, creditbalance increases in thefirms books butnot in banks books until the cheque is cleared and money realized. This is called as ________________. 6. AccordingtoBaumolmodel,thetotalcostassociatedwithcashmanagementhastwoelements ______________and____________. 7. TheMOmodelassumesthatcashbalancesrandomlyfluctuatebetweena____________anda __________________. 12.6

Summary

Allcompaniesarerequiredtomaintainaminimumlevelofcurrentassetsatallpointsoftime. Cash management is concerned with determination of relevant levels of cash balances and near cash assetsandtheirefficientuse. The need for holding cash arises due to a variety of motives transaction motive, speculation motive, precautionary motive and compensating motive. The objective of cash management is to makeshorttermforecastsofcashinflowsandoutflows,investingsurpluscashandfindingmeansto arrangeforcashdeficits.CashbudgetshelpFinanceManagertoforecastthecashrequirements.
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TerminalQuestions 1. MirajEngineeringCo.hasforecastitssalesforthe3monthsendingDec.asfollows: Oct.Rs.500000NovRs.600000Dec.Rs.650000 Thegoodsaresoldoncashandcreditbasis50%each.Creditsalesarerealizedinthemonth followingthesale.Purchasesamountto50%ofthemonthssalesandarepaidinthefollowing month. Wages and administrative expenses per month amount to Rs. 150000 and Rs. 80000
st respectively and are paid in the following month. On 1 Dec. the company has purchased a th st testingequipmentworthRs.20000payableon15 Nov.On31 Dec.acashdepositwithabank st will mature for Rs. 150000. The opening cash balance on 1 Nov. is Rs. 100000.What is the

closingbalanceinNov.andDec.? 2. Michael Industries Ltd. requests you to help them in preparing a cash budget for the period endingDec.2007. Rs.inlakhs Particulars May Sales Materials Rent Salaries Misc charges Taxes Purchase ofasset 15 7 June 20 20 July 22 22 0.50 1.5 0.15 Aug 3 29 0.5 2 0.2. Sep 34 15 0.5 2.5 0.2 Oct 25 15 0.50 1.5 0.4. 4 Nov 25 8 0.5 1 0.3. 10 Dec Jan 15 8 0.5 1 0.2 15 Nil

Creditterms:Customersareallowed1monthtime. Suppliersofmaterialsarepaidafter2months. Thecompanypayssalariesafteragapof15days. Rentispaidafteragapof1month.

st ThecompanyhasanopeningbalanceofRs.200000on1 June. st Prepareacashbudgetandfindoutwhatistheclosingcashbalanceon31 Dec.

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AnswerstoSelfAssessmentQuestions SelfAssessmentQuestions1 1. Deficitfinancingorinvestingsurpluscash 2. Transaction,speculative,precautionaryandcompensating 3. Precautionary 4. Tradecredit 5. Collectionfloat 6. Costofconversionofmarketablesecuritiesintocashandopportunitycost. 7. Upperbound(uppercontrollimit)andlowerbound(lowercontrollimit). AnswertoTerminalQuestions 1.PrepareaCashBudgetforNovemberandDecember.RefertotheExample12.5.4 2.PrepareacashbudgetasshowninExample12.5.4.

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