Cash Management

Prof Anita C Raman, IBS Hyd.

 What is Cash ..?
• Cash means notes and coins….

• bank drafts & deposits with-drawable on demand

• marketable securities (eg. FDs & Money Market Mutual Funds)
immediately sold or converted into cash.
NEED FOR AND OBJECTIVE OF CASH
MANAGEMENT

Profitability Liquidity

• Loss of reputation • Loss of Interest costs

/ opportunities
 Motives of cash management
• Transaction motive:
• Maintaining cash to deal with routine transactions
• Precautionary Motive:
• Maintaining cash to deal with contingencies or to minimize its losses
• Speculative Motive:
• Maintaining cash to take advantage of opportunities that do not take place in the
course of routine business activities.
Cash Management Objectives

•Objectives of Cash Management

• amount of cash to be maintained by a company
• Maximize value on incoming funds & return on
excess funds
• Minimize the cost of borrowing
• Integrate banking services with accounting and
treasury functions
• Process information quickly and accurately
• Move it, manipulate it, report it and transmit it

Prof Anita C Raman 5

Cash management cycle

Cash Forecasting
Cash Surplus : minimizing idle cash
Cash Deficits : finding avenues for financing
Prof Anita C Raman 6
 How to Manage Cash..?
• Cash budget is concerned with cash inflows and outflows.
• Principal tool - cash budgeting (short-term cash forecasting)
• Cash budgets are prepared for one year (3 M, 1M or week)
• The information generated during the preparation of operating budgets
such as sales forecasts, wages and salaries, manufacturing expenses
overheads etc., will become useful.

Prof Anita C Raman 7

 Cash Reports
• Cash reports will be served when cash inflows and outflows do not
fluctuate very much and the collection and payment patterns are
stabilized.
• What is the utility of Cash report?
• High uncertainty in the cash flows, then the need arises to monitor
information on the cash position more frequently on a weekly or
sometimes on daily basis and to revise the budget.

Prof Anita C Raman 8

Cash Report/Budget
1 Opening Cash Balance –
.
2 Receipts –
.
Cash sales ***
Collection on Credit Sales ****
Loans ****
Others Receipts ****
3 Payments ***
.
Cash Purchases ****
Payment to Creditors ****
Repayment of Loans ****
Other Payments
4 Net Cash flow (2-3) ****
. Prof Anita C Raman 9

Closing Cash Balance (1 + 4) ***

 Cash Budget
The following additional information is provided: Find the closing balance and the investment for
the 3 months Jan- March by preparing cash budget.
· Thirty percent of the company’s sales are for cash and the remaining are collected in the
month following the sale.
· Cost of sales amount to 75 percent of sales. Out of which 40 percent are raw material costs
and 60 percent are direct labor costs.
· Direct labor costs are paid in the month incurred.
· Raw materials are paid in the month following the purchase.
· Total of other operating expenses amount to Rs.3,00,000 per month.
· A capital expenditure of Rs.1,50,000 has been planned in February.
· Tax payments of Rs.1,80,000 are to be made in March.
· The company maintains a cash balance equal to 10 percent of the previous months cost of
sales. The surplus cash is invested in bank deposits based on the future requirements.
· Sales in the month of December were Rs.21,00,000.

Month Expected sales

January Rs.20,00,000
February Rs.16,00,000
Prof Anita C Raman 10
March Rs.10,00,000
 Cash Budget
Month January February March
Sales 20,00,000 16,00,000 10,00,000
Inflows
Collections: Current month’s
Previous month’s
Total cash receipts
Outflows
Raw material cost
Direct labor cost
Other operating expenses
Capital expenditure
Tax payments
Total cash payments
Net cash flow
Opening cash balance
Desired closing cash balance
Investment
Prof Anita C Raman 11
 Cash Budget
Month January February March
Sales 20,00,000 16,00,000 10,00,000
Inflows
Collections: Current month’s 6,00,000 4,80,000 3,00,000
Previous month’s 14,70,000 14,00,000 11,20,000
Total cash receipts 20,70,000 18,80,000 14,20,000
Outflows
Raw material cost 6,30,000 6,00,000 4,80,000
Direct labor cost 9,00,000 7,20,000 4,50,000
Other operating expenses 3,00,000 3,00,000 3,00,000
Capital expenditure — 1,50,000 —
Tax payments — — 1,80,000
Total cash payments 18,30,000 17,70,000 14,10,000
Net cash flow 2,40,000 1,10,000 10,000
Opening cash balance 1,57,500 1,50,000 1,20,000
Desired closing cash balance 1,50,000 1,20,000 75,000
Investment 2,47,500
Prof Anita C Raman
1,40,000 55,00012
 Which factors would bring efficency in CM?
❑Prompt Billing and Mailing
❑preparing invoice documents and mailing the same to the
customers to minimize the time gap

❑Collection of Cheques and Remittance of Cash

❑hastening the process of collecting and depositing cheques/cash from
customers.
❑Centralized Purchases and Payments to Suppliers

❑Discounts can be availed on bulk purchases

❑Arrangements can be made with the suppliers for direct shipment of material to
different units located, to minimize transportation and handling and storage
costs.

Prof Anita C Raman 13

 • Playing with Float
• Whenever cheques are deposited
What is float ? with the bank, the credit balance
increases in the company’s books of
Arises from the practice account but not in the books of the
of banks not to credit bank until the cheques are cleared
the customer’s account and money realized.
in its books when a
cheque is deposited by • The amount of cheques deposited by
him and not to a company in the bank awaiting
clearance is called ‘collection float’.
debit his account in its
books when a cheque is • Similarly, the amount of cheques
issued by him until the issued by the company awaiting
cheque is cleared and payment by the bank is called
cash is realized or paid ‘payment float’. The difference
respectively between ‘payment float’ and
‘collection float’ is called ‘net float’.

Prof Anita C Raman 14

Lockbox System Concentration Banking
• Customers send their ❑Payments are made at Collection
payments/cheques to a nearby Centres (CC),
post box . ❑ From CCs Cheques are then
deposited in local banks
• Clearance of PB is done
❑ Decentralised billing and multiple
several times cheques
deposited in firms’ bank and is collection points, expedites the
remitted into the firm’s collection of accounts receivable.
❑ It reduces postal float , lethargy
account;
and bank float ( the time needed in
• This reduces float by the collection process by reducing
shortening the lethargy as well the mailing time.
as postal and bank floats.

Prof Anita C Raman 15

Investment of Surplus Cash

• Investing surplus cash involves two basic problems:

• i. Determining the amount of surplus cash
• The amount of cash available over and above minimum level may be termed as a
‘safety level for cash.’

• During Normal periods

Safety level of cash = Desired days of cash x Average daily cash outflows
• During Peak Periods
• Safety level of cash = Desired days of cash at the business period x
Average of highest daily cash outflows

Prof Anita C Raman 16

Determining Cash Need

There are two approaches to derive an optimal cash

balance, namely,
a) minimising cost cash models and
b) cash budget.
Cash Management/Conversion Models
1) Baumol Model,
2) Miller-Orr Model and
3) Orgler’s Model.

Prof Anita C Raman 14-17

Baumol Model
provides for cost efficient transactional balances and assumes that the
demand for cash can be predicted with certainly and determines the optimal
conversion size/lot.
to minimise the total cost total conversion costs (that is, costs incurred
each time marketable securities are converted into cash)
and the opportunity cost ( keeping idle cash balances which otherwise
could have been invested in marketable securities).
The total cost associated with cash management, according to this model,
has two elements:
(i) cost of converting marketable securities into cash and
(ii) the lost opportunity cost.
The conversion costs are incurred each time marketable securities are
converted into cash. Symbolically,
Tb
Total conversion cost per period = (1)
C
Where b = cost per conversion assumed to be independen t of the size of the transactio n,
T = total transactio n cash needs for the period,
C = value of marketable securities sold at each conversion .

Prof Anita C Raman

 Baumol Model

cost efficient transactional

balances and assumes that
the demand for cash can be
predicted with certainly and
determines the optimal
conversion size/lot.
The focus is to minimise the
total cost associated with cash
management comprising total
conversion costs (that is,
costs incurred each time
marketable securities are
converted into cash) and the
opportunity cost of keeping
idle cash balances which
otherwise could have been
invested in marketable
securities.

Prof Anita C Raman 19

The opportunity cost is derived from the lost/forfeited interest rate (i) that
could have been earned on the investment of cash balances. The model
assumes a constant and a certain pattern of cash outflows. At the
beginning of each period, the firm starts with a cash balance which it
gradually spends until at the end of the period it has a zero cash balance
and must replenish its each supply to the level of cash balance in the
beginning. Symbolically, the average lost opportunity cost.
 
iC






(2)

 2 


i= interest rate that could have been earned.

C/2= the average cash balance that is, the beginning cash (C) plus the ending cash
balance of the period (zero) divided by 2.
The total cost associated with cash management comprising total conversion cost plus
opportunity cost of not investing cash until needed in interest-bearing instruments can
be symbolically expressed as:
   
i C  +  Tb  (3)
 2  C 

Prof Anita C Raman 14-20

Example 1
The ABC Ltd requires Rs 30 lakh in cash to meet its transaction needs
during the next three-month cash planning period. It holds marketable
securities of an equal amount. The annual yield on these marketable
securities is 20 per cent. The conversion of these securities into cash entails
a fixed cost of Rs 3,000 per transaction. Using Baumol model, compute the
amount of marketable securities converted into cash per order. Assuming
ABC Ltd can sell its marketable securities in any of the five lot sizes: Rs
1,50,000, 3,00,000, 6,00,000, 7,50,000 and 15,00,000, prepare a table
indicating the economic lot size using numerical analysis.

Prof Anita C Raman 14-21

Optimal Cash Conversion Size/Lot

1. Total cash requirement (Rs lakh) 30 30 30 30 30

2. Lot size (Rs lakh) 1.5 3 6 7.5 15

3. Number of lots (1 ÷ 2)

4. Conversion cost per lot (Rs thousand)

5. Total conversion cost (3 × 4) (Rs

thousand)

6. Average lot size (Rs lakh)

7. Interest cost (6 × 0.05) (Rs)

8. Total cost (5 + 7) (Rs)

The optimal cash conversion size is Rs 6 lakh.

Prof Anita C Raman 14-22

Optimal Cash Conversion Size/Lot

1. Total cash requirement (Rs lakh) 30 30 30 30 30

2. Lot size (Rs lakh) 1.5 3 6 7.5 15

3. Number of lots (1 ÷ 2) 20 10 5 4 2

4. Conversion cost per lot (Rs thousand) 3 3 3 3 3

5. Total conversion cost (3 × 4) (Rs 60 30 15 12 6

thousand)

6. Average lot size (Rs lakh) 0.75 1.5 3 3.75 7.5

7. Interest cost (6 × 0.05) (Rs) 3,750 7,500 15,000 18,750 37,500

8. Total cost (5 + 7) (Rs) 63,750 37,500 30,000 30,750 42,500

The optimal cash conversion size is Rs 6 lakh.

Prof Anita C Raman 14-23

Example 1
The ABC Ltd requires Rs 30 lakh in cash to meet its transaction needs
during the next three-month cash planning period. It holds marketable
securities of an equal amount. The annual yield on these marketable
securities is 20 per cent. The conversion of these securities into cash entails
a fixed cost of Rs 3,000 per transaction. Using Baumol model, compute the
amount of marketable securities converted into cash per order. Assuming
ABC Ltd can sell its marketable securities in any of the five lot sizes: Rs
1,50,000, 3,00,000, 6,00,000, 7,50,000 and 15,00,000, prepare a table
indicating the economic lot size using numerical analysis.
Solution
2bT
C= ,
i
C = optimal conversion amount/amount of marketable securities converted
into cash per order;
b = cost of conversion into cash per lot/transaction;
T = projected cash requirement during the planning period;
i = interest rate earned per planning period on investment in marketable
securities

Prof Anita C Raman 14-24

Example 1
The ABC Ltd requires Rs 30 lakh in cash to meet its transaction needs
during the next three-month cash planning period. It holds marketable
securities of an equal amount. The annual yield on these marketable
securities is 20 per cent. The conversion of these securities into cash entails
a fixed cost of Rs 3,000 per transaction. Using Baumol model, compute the
amount of marketable securities converted into cash per order. Assuming
ABC Ltd can sell its marketable securities in any of the five lot sizes: Rs
1,50,000, 3,00,000, 6,00,000, 7,50,000 and 15,00,000, prepare a table
indicating the economic lot size using numerical analysis.
Solution
2bT
C= ,
i
where C = optimal conversion amount/amount of marketable securities
converted into cash per order; b = cost of conversion into cash per
lot/transaction; T = projected cash requirement during the planning period; i
= interest rate earned per planning period on investment in marketable
securities
2  Rs 3,000  Rs 30,00,000
= = Rs 6,00,000 @Annual yield 20%/4 = 5%
0.05 @

Prof Anita C Raman 14-25

Stochastic Models :Miller and orr model

The model sets higher and

lower control limits, H and L,
respectively, and a target cash
balance, Z.
When the cash balance reaches
H, then (H-Z) dollars are
transferred from cash to
marketable securities, i.e. the
firm buys (H-Z) dollars of
securities.
Similarly when the cash
balance hits L, then (Z-L) dollars
are transferred from
marketable securities to cash.
Prof Anita C Raman 26
 Miller-orr model
• The lower limit, L is set by management depending upon how much risk of a
cash shortfall the firm is willing to accept, and this, in turn, depends both on
access to borrowings and on the consequences of a cash shortfall.
• The formulae for the Miller-Orr model are:
• Return point = Lower limit + (1/3 × spread)
• Spread = 3 [ (3/4 × Transaction cost × Variance of cash flows) ÷ Interest rate ] 1/3
• Note: variance and interest rates should be expressed in daily terms.
• Variance = standard deviation squared.

Prof Anita C Raman 27

Example 2
The management of Popular Traders anticipates Rs 15 lakh in cash outlays
(demand) during the next year. The recent experience has been that it costs
Rs 30 to convert marketable securities to cash and vice versa. The
marketable securities currently earns 8 per cent annual return. Find the total
cost of managing cash according to Banmol model.
Solution

Prof Anita C Raman 14-28

Example 2
The management of Popular Traders anticipates Rs 15 lakh in cash outlays
(demand) during the next year. The recent experience has been that it costs
Rs 30 to convert marketable securities to cash and vice versa. The
marketable securities currently earns 8 per cent annual return. Find the total
cost of managing cash according to Banmol model.
Solution

2  Rs 30  Rs 15,00,000
Economic/o ptimal conversion size/lot = = Rs 33,541
0.08

Number of conversions = Rs 15,00,000 ÷ Rs 33,541 = 45

Average cash balance = Rs 16,770.50 (Rs 33,541 ÷ 2)
Total cost = (Rs 30 × 45) + (0.08 × Rs 16,770.50) = Rs 2,692

Prof Anita C Raman 14-29

Thus, as in Baumol Model, there are economies of scale in cash
management and the two basic costs of conversion and lost interest
that have to be minimized.
MO Model also specifies the optimum upper boundary (b) as three
times the optimal cash balance level such that
b = 3z (7)
Further, the financial manager could consider the use of less liquid,
potentially more profitable securities as investments for the cash
balances in excess of h.

Prof Anita C Raman 14-30

Miller-Orr Model
Miller-Orr Model is a model that provides for cost-efficient transactional
balances and assumes uncertain cash flows and determines an upper limit
and return point for cash balances.
The objective of Miller-Orr Model is to determine the optimum cash balance
level which minimises the cost of cash management.

C = bE(N ) + iE(M ) (5)

t
where b = the fixed cost per conversion, E (M) = the expected average daily
cash balance, E (N) = the expected number of conversions, t = the number of
days in the period, i = the lost opportunity costs, and C = total cash
management costs
According to the MO Model, as in Baumol model, the optimal cash balance (z)
can be expressed symbolically as

3br 2
z= (6)
4i
where r 2 = the variance of the daily changes in cash balances.

Prof Anita C Raman 14-31

Example 3
Assuming for Popular Traders in above example 2 that variance of
daily net cash flows is estimated to be Rs 27,000, show the cash
balances as per Miller-Orr model.
Solution

2
z = 3br (6)
4i
where r 2 = the variance of the daily changes in cash balances.

Prof Anita C Raman 14-32

Example 3
Assuming for Popular Traders in Example 2 that variance of daily net
cash flows is estimated to be Rs 27,000, show the cash balances as
per Miller-Orr model.
Solution

Return point = 3  Rs 30  Rs 27,000 = Rs 1,399

4  0.000222@
@daily portfolio return= (8% ÷ 360 days)
upper limit = 3 × Rs 1,399 = Rs 4,197
The cash balance of Popular Traders would be allowed to vary
between Re 0 (zero) and Rs 4,197. When the upper limit is reached,
Rs 2,798 (Rs 4,197 – Rs 1,399) is converted from cash to marketable
securities that will earn interest. When the cash balance falls to zero,
Rs 1,399 (Rs 1,399 – Re 0) is converted from marketable securities
into cash.
Prof Anita C Raman 14-33
•Thank Q
•Any Q?

Prof Anita C Raman 34