Working Capital Management - Cash Management

CASH MANAGEMENT

          Cash is the money which a firm can disburse immediately without any restriction and includes coins, currencies and cheques held by the firm and balances in its bank accounts. Cash management is concerned with the managing of: cash flows into and out of the firm; cash flows within the firm; and cash balances held by the firm at a point of time by financing deficit or investing surplus cash.

Cash Holding motives:

• Transaction motive: It is a motive for holding cash or near cash items to meet routine cash requirements such as purchase of raw materials, pay expenses, taxes, dividends, etc. This motive mainly refers to holding cash to meet anticipated payments whose timing is not perfectly matched with the cash receipts.
• Precautionary motive: It is a motive for holding cash or near cash items as a cushion to meet the contingencies in the future. The precautionary cash may be kept in cash and (high liquid and low risk) marketable securities.
• Speculative motive: It is a motive for holding cash for investing in profit making opportunities as and when they arise typically outside the normal course of the business.

Cash Planning:

          Cash planning is a technique to plan and control the use of cash thus protecting the financial condition of the firm by developing a projected cash statement based on the present operations or the anticipated operations. Cash budget, a summary statement of the firm’s expected cash inflows and outflows over a projected time period, is the most significant device to plan for and control cash receipts and payments based on short-term or long-term forecasting needs.

Short term forecasting methods: These are particularly done to determine operating cash requirements, to anticipate short-term financing and to manage investment of surplus cash. Two most commonly used methods are

• Receipts and disbursements method: - This method is generally employed to forecast for a limited period (week or months). The prime aim of this method is to summarize the cash inflows and outflows during a predetermined period.
• Adjusted net income method: This method involves the tracing of working capital flows. The objectives of this method is to project the company’s need for cash at a future date and to show whether the company can generate the required funds internally.

Long term forecasts are prepared to give an idea of the company’s financial requirements in the distant future which reflects the impact of growth, expansion or acquisitions.

Cash Management Techniques:

Cash can be managed by accelerating cash collections and slowing disbursements.

• To accelerate cash collections, business firms can encourage the customers to pay promptly by offering discounts, early bird offers and also use prompt payments like billing devices.
• To reduce the firm’s deposit float, it can attempt to speed up the mailing, processing and collection times.
• To minimize the mailing time between the firm and customers, concentration banking – a decentralized collection procedure in which payments are made to regionally dispersed collection centers and deposited in local banks for quick clearing.
• Lock box system is one such technique to speed up the processing and mailing time in which payers send their payments or cheques to a nearby post box that is cleared by the firm’s bank. The local banks are authorized to open the box and pick up the remittances received from the customers.
• Slowing disbursement of cash is possible by avoiding the early payment of cash and by centralized disbursement system.

Cash Management Models:

Baumol Model – Inventory Model (EOQ):

Objective: To determine the minimum cost amount of cash conversion and the lost opportunity cost

Assumptions:

• Demand for cash, transaction costs and holding costs are given and do not change during that period
• There is a constant demand for cash during the given period 
• Cash payments are predictable
• No restrictions from banks for maintenance of minimum cash balances in the bank accounts

Formula:

Total conversion cost per period, t = Tb/ C

                    T= Total transaction cash needs for the period

                    b = Cost per conversion

                    C = Value of marketable securities

Opportunity cost, i = C/2

                    i = Interest rate earned

                    C/2 = Average cash balance 

Optimal cash conversion amount, C =√2 *(2bT/i)

 

Miller- Orr Model – Stochastic Model:

Objective: To determine the optimum cash balance level which minimizes the cost of management of cash

Assumptions:

• The cash inflows and outflows are stochastic
• The daily cash balance is normally distributed
• There is a possibility to invest idle cash in marketable securities
• The business maintains the minimum acceptable cash balance – the lower limit

Formula:

The return point of the cash balance can be calculated as:

Return point = Lower limit + 1/3 * Spread

Spread = 3 *(√3 ((3Fσ^2)/(4K)))

Where F= Transaction cost

K = opportunity cost

σ² = Variance of daily cash balance

 

Upper limit = Lower limit + Spread

Limitations:

•  An increase in transaction cost results in an increase in spread and a higher return point
• A higher volatility of the daily cash balance means higher probability of reaching lower or upper limit

Orgler’s model:

          This model provides for the integration of cash management with production and other aspects of the business concern. Multiple linear programming is used to determine the optimal cash management based on the set of objectives of the firm and specifying the set of constraints of the firm