CASH AND LIQUIDITY

MANAGEMENT

Centre for Financial Management , Bangalore

2015 by McGraw Hill Education (India) Private Limited

Chapter 24

OUTLINE
Motives for Holding Cash
Cash Budgeting
Long-term Cash Forecasting
Reports for Control
Cash Collection and Disbursement
Optimal Cash Balance
Investment of Surplus Funds
Cash Management Models

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MOTIVES FOR HOLDING CASH

Keynes identified three possible motives for holding cash :
Transaction motive
Precautionary motive
Speculative motive

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CASH BUDGET
The principal method of cash budgeting is the receipts and disbursements method.
Under this method, the cash forecast shows the timing and magnitude of cash receipts
and disbursements over the forecast period.

Illustration
The following information about Beta Company is given:
The estimated sales for the period January 20X1 through June 20X1 are as
follows: Rs.100,000 a month from January through March and Rs.120,000 a
month from April through June.
The sales for November and December of the previous year have been
Rs.100,000 each.
Cash and credit sales are expected to be 20 percent and 80 percent respectively.
The receivables from credit sales are expected to be collected as follows: 50
percent after one month and the balance 50 percent after two months.
Other anticipated receipts are: Rs.5,000 from the sale of a machine in March and
Rs.2000 interest on securities in June.

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CASH BUDGETING
January
1. Sales
2. Credit sales
3. Collection of
accounts
receivables
4. Cash sales
5. Receipt from
machine sale
6. Interest
Total cash
receipts

(3+4+5+6)

February

March

April

100,000

100,000

80,000

80,000

80,000

96,000

80,000
20,000

80,000
20,000

80,000
20,000

80,000
24,000

May

June

100,000 120,000 120,000 120,000

96,000

96,000

88,000 96,000
24,000 24,000

5,000
2,000
100,000

100,000

105,000 104,000 112,000 122,000

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CASH BUDGETING
Relevant information for cash payments
Beta Company plans to purchase materials worth Rs.40,000 in January and
February and materials worth Rs.48,000 each month from March through
June. Payments will be made a month after the purchase
A payment of Rs.40000 will be made in January for purchases in the previous
December
Miscellaneous cash purchases of Rs.2000 per month are planned from January
through June
Wage payments will be Rs.15000 per month, January through June
Payments for manufacturing expenses will be Rs.20,000 per month and for
general administrative expenses will be Rs.10,000 per month, January through
June
Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for
June
A machine will be bought in cash for Rs. 50,000 in March

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CASH BUDGETING
January

February

March

April

May

June

1. Material
purchases
40,000
40,000
48,000
48,000
48,000 48,000
2. Credit material
purchases
40,000
40,000
48,000
48,000
48,000 48,000
3. Payment of
40,000
40,000
40,000
48,000
48,000 48,000
accounts
payable
4. Miscellaneous
2,000
2,000
2,000
2,000
2,000
2,000
cash purchases
5. Wages
15,000
15,000
15,000 15,000
15,000 15,000
6. Manufacturing
exp.
20,000
20,000
20,000 20,000
20,000 20,000
7. General admn.
expense
10,000
10,000
10,000 10,000
10,000 10,000
8. Dividend
20,000
9. Tax
20,000
10. Capital
50,000
expenditure
Total payments
87,000
87,000
137,000 95,000
95,000 135,000
(3+4+5+6+7+8+9+10)

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CASH BUDGETING
Assuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balance
required by the firm is Rs.20,000, the summary cash forecast is given below.
January
1. Opening cash
balance

February

March

April

May

June

Rs.22,000

2. Receipts
3. Payments

100,000
87,000

100,000
87,000

105,000 104,000

137,000

95,000

112,000 122,000

95,000 135,000

4. Net cash flow (2 3)

13,000

13,000

(32,000)

9,000

17,000 (13,000)

5. Cumulative net
cash flow

13,000

26,000

(6,000)

3,000

20,000

7,000

6. Opening cash
balance +
Cumulative net flow (1 + 5)

35,000

48,000

16,000

25,000

42,000

29,000

7. Minimum cash balance

required

20,000

20,000

20,000

20,000

20,000

20,000

15,000

28,000

(4,000)

5,000

22,000

9,000

8. Surplus or deficit in
relation to the minimum
cash balance required
(6 7)

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LONG-TERM CASH FORECASTING

Adjusted net income method is generally used for long-term cash
forecasting.
20 X 0
Source
Net income after taxes
Non-cash charges
(Depreciation, amortisation,
etc.)
Increase in borrowings
Sale of equity shares
Miscellaneous
Uses
Capital expenditures
Increase in current assets
Repayment of borrowings
Dividend payment
Miscellaneous
Surplus/ Deficit
Opening cash balance
Closing cash balance

20 X 1

20 X 2

20 X 3

20 X 4

REPORTS FOR CONTROL

Daily Cash Report

Daily Treasury Report

Monthly Cash Report

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CASH COLLECTION AND DISBURSEMENT

Float
Speeding up Collections
Delaying Payments
EDI : Will the Float Disappear

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FLOAT
The cash balance shown by a firm on its books is called
the book, or ledger, balance whereas the balance shown
in its bank account is called the available, or collected,
balance. The difference between the available balance
and the ledger balance is referred to as float.
There are two kinds of float viz., disbursement float and
payment float

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OPTIMAL CASH BALANCE

Total costs
Opportunity cost
Costs

C*

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Transaction cost

Cash balance

INVESTMENT OF SURPLUS FUNDS

It may be useful to divide a firms short-term investment
portfolio into three segments:
Ready cash segment
Controllable cash segment
Free cash segment

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CRITERIA FOR EVALUATING

INVESTMENT OPTIONS
Safety
Liquidity
Yield
Maturity

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INVESTMENT OPTIONS
Fixed deposits with banks
Treasury bills
Mutual fund schemes
Money market schemes
Commercial paper
Certificates of deposit
Inter-corporate deposits
Ready forwards
Bill discounting

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ELEMENTS OF CASH AND LIQUIDITY

MANAGEMENT
In recent years the importance of cash and liquidity
management has increased dramatically. Cash
management comprises of five basic elements.
1. Collection The firm must accelerate the receipts
into available funds.
2. Disbursement The firm must control the release
and timing of funds.
3.
Concentration The firm must inexpensively
mobilise funds from outlying banks to a single
location for their efficient use.
4. Investment The firm must maximise yield within
acceptable limits of risk and maturity.
5. Information and Control The firm must develop
reliable
short term cash forecasts and obtain
accurate, timely data on bank balances, bank

CASH MANAGEMENT MODELS

Several cash management models have addressed this issue of
split between marketable securities and cash holdings. Two
such models are :
Baumol model
Miller and Orr model

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BAUMOL MODEL
2bT
C=
I
where: C = amount of marketable securities converted into cash
per order
I = interest rate per planning period on investment in
marketable securities.
T = Projected cash requirements during the planning
period

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MILLER AND ORR MODEL

3b 2
RP = 3
+ LL
4I
UL = 3RP 2LL
where: RP = return point
b = fixed cost per order for converting marketable
securities into cash.
I = daily interest rate earned on marketable securities
2 = variance of daily changes in the expected cash balance
LL = the lower control limit
UL = the upper control limit

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SUMMING UP
There are three possible motives for holding cash, viz., transaction
motive, precautionary motive, and speculative motive.
The principal method of short-term cash forecasting is the receipts
and payment method.
The method generally used for long-term forecasting is the adjusted
income method.
To enhance the efficiency of cash management collections and
disbursements must be properly monitored.
A variety of options are there for investing surplus funds available
for short periods.
William Baumol has proposed a model which applies the EOQ
concept to determine the cash conversion size.
Expanding on the Baumol model, Miller and Orr consider a
stochastic generating process for periodic changes in cash balance.

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