Chapter 27 Cash and Liquidity Management

8/3/2019 Chapter 27 Cash and Liquidity Management

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Chapter 27

CASH AND LIQUIDITY

MANAGEMENT

Centre for Financial Management , Bangalore


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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 amonth 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 February March April May June

1. Sales 100,000 100,000 100,000 120,000 120,000 120,000

2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000

3. Collection of

accounts

receivables 80,000 80,000 80,000 80,000 88,000 96,0004. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000

5. Receipt from

machine sale 5,000

6. Interest 2,000Total cash

receipts 100,000 100,000 105,000 104,000 112,000 122,000

(3+4+5+6) Centre for Financial Management , Bangalore


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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 Januarythrough 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 throughJune

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 48,0002. 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 48,000accountspayable

4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000cash purchases

5. Wages 15,000 15,000 15,000 15,000 15,000 15,000

6. Manufacturingexp. 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 10,0008. Dividend - - - - - 20,000

9. Tax - - - - - 20,000

10. Capital - - 50,000 - - -expenditureTotal 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 February March April May June1. Opening cash

balance Rs.22,000

2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000

3. Payments 87,000 87,000 137,000 95,000 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

8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000

relation to the minimumcash 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 20 X 1 20 X 2 20 X 3 20 X 4

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 assetsRepayment of borrowings

Dividend payment

Miscellaneous

Surplus/ Deficit

Opening cash balance

Closing cash balance


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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 balanceand the ledger balance is referred to as float.

There are two kinds of float viz., disbursement float andpayment float



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OPTIMAL CASH BALANCE

C*

Costs

Total costs

Opportunity cost

Transaction cost

Cash balance



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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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CASH MANAGEMENT MODELS

Several cash management models have addressed this issueof 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

3b2RP = 3 +LL

4I

UL = 3RP2LL

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 balanceLL = the lower control limit

UL = the upper control limit


S G


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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 receiptsand 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.

Centre for Financial Management Bangalore

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Chapter 27 Cash and Liquidity Management